Interview Questions Flashcards

Question

What are our greatest weaknesses?

Answer 1

This question is rarely asked. It is designed to test your knowledge (and therefore level of interest) in the bank. Usually it is advisable to point out some “non-dangerous” areas of improvement for the bank, such the lack of presence in Asia or lack of leverage or their unique international footprint.

Answer 2

Consider yourself fortunate if you get this question. It is an opportunity to sell yourself on why banking, why this bank and why you. Do not make the mistake of not sounding sufficiently humble. The Analyst or Associate role requires a lot of self-confidence but also a good degree of humbleness. There will be a times when you will have to follow the guidelines of senior bankers even if you disagree or don’t fully understand them. Moreover, no one likes to work with overly narcissistic people. They are a problem for everyone.

Answer 3

There is no perfect answer. However, you are in an interview and you should show commitment and thoughtful planning. Some non-dangerous answers may be: - Small boutique bank in order to gain enough experience and then re-apply for a bulge bracket - M&A/business development at a corporation - Project finance for a lending bank - Small cap PE fund

Answer 4

It is another question designed to test your knowledge of the market. It’s advisable to choose a bank with similar characteristics of the one you are interviewing for. For example a good comparable for J.P. Morgan would be Citi, highlighting their ability to cross sell products leveraging their lending capabilities. A good comparable for Morgan Stanley would be Goldman Sachs, saying that you really appreciate their pure investment banking model and their culture for excellence.

Answer 5

This is part of the “tell me about a time…” questions and is supposed to show the interviewer how you handle situations involving stress and emotions. What did you learn and what was your role? Your answer should be tailored such that the skills demonstrated should be the ones relevant to be a good Analyst or Associate. Good examples usually include a project that did not go as planned or a work situation that did not develop as expected. Avoid empty statements like my greatest failure was not getting a job at Morgan Stanley right after undergrad. Also avoid big mistakes. It is advisable to use real situations and then show how you used the failure to progress and learn, and how the next time you handled the same situation brilliantly.

Answer 6

The interviewer is going to judge if you are a good fit for banking. Answer using the qualities described earlier for a good Analyst or Associate.

Answer 7

Welcome this question as a great opportunity to talk about your unique selling points. It is a variation of the three major strengths, but you should back-up your qualities with examples from your professional background.

Answer 8

This is a delicate question and you should treat it accordingly. No one is perfect, so there is no fault in admitting it. Say a real weakness and most important tell the interviewer how you have been working on it and the improvements you have already achieved. However, avoid suicidal statements such as “I do not like working in teams” or “I am not good with numbers” or “I lose control under stress”.

Answer 9

This question is a variation of the three major strengths. The interviewer is just trying to figure out if you would be a good addition to the team. Answer using the qualities described earlier in order to convey the right message. For each word you list you should also give an explanatory sentence, possibly recalling a short anecdote.

Answer 10

Many students live these questions with anxiety. You should not, it is indeed another opportunity to sell yourself. It is a variant of the weaknesses question, but with the caveat that you should tell an anecdote of your past possibly related to a misunderstanding / team working situation. For example a time when you were in charge of delivering a project for the client and one of the advisors (for example the legal) was not delivering their work on time putting the entire operation at risk, so you had to step down and “push” in order to make the process flow again.

Answer 11

This is a variation of the strengths question and represents another great opportunity to sell your unique marketing points. Just ensure that you support your statements with real anecdotes.

Answer 12

There is no right answer. It all depends on how your interview is going. You can view it as a variance of the weaknesses question. If the interview is going well and it appears that you would be a good fit, you can answer with a joke like “if you did not hire me you would probably not hire at all” or “I sincerely do not see any plausible reason!” Another option is to try to think about the recruiter’s perspective. Figure out what about your profile would worry a recruiter, and then convince them about how that is not a weakness at all. Make sure you support your statement with a relevant story from your professional background.

Answer 13

All interviews end with this question. The worst response to this question is, I have none. The interviewer wants to understand if you are naturally curious and can ask intelligent questions. It is another great opportunity to show how thoughtful your research has been and how well you would you fit in their team. Here is a suggestion on some common questions to ask: - Interviewer background: how did you get started in banking? Why did you choose your group? - Ask for advice: what distinguishes a good Analyst or Associate from a great Analyst or Associate? What are the key factors that make a summer internship successful? - Discussion: you can ask senior bankers on their view of their sector. While this is usually appreciated, you should be prepared to discuss the topic. While these are all good questions, you should try to use your intelligence and creativity. Final questions are a way of differentiating yourself.

Answer 14

You should talk about an experience when you were requested to take the lead of your team and successfully obtained the results you waited for. • Start by stating the situation/problem and the objective. • Describe the team and relative roles. Explain how you delegated/managed the work flow. • State the results of your work and the client’s reaction. This is also a good opportunity to talk about how you manage expectations with your seniors and how you can work well with others, try to state anecdotes and prove that you have the required skills of an Analyst or Associate.

Answer 15

There is no right answer, but a “balanced” approach is advisable. The best Associate or even Senior Analyst is able to lead analysts and leave them with a good grade of independency but at the same time will take responsibility/double checking (the mistakes of analysts) for delivering the output in time and with no mistakes.

Answer 16

It is strongly recommended you use a story when a team wasn’t working until you began to fix it. Never be negative in an interview, therefore you should avoid pointing the finger against someone in particular. Many students take a situation where there was a personality clash between two members of the team (ensure you are NOT one of the two) which was blocking the workflow; and then explain how they worked to “bridge” the two antagonist’s positions, ultimately allowing the group to deliver results.

Answer 17

The truth is you must be both (be a balanced person!). A good Analyst or Associate must be versatile and take the lead or take advice and follow, according to the team’s needs.

Answer 18

The answer is your opportunity to talk about a situation where you stayed calm and effectively managed the situation.

Answer 19

As said before, of course you like it. Efficient teams achieve the greatest results and in the shortest time.

Answer 20

Teamwork questions are meant to test your knowledge of the work of an Analyst or Associate. They want to know if you will work well with senior bankers, peers in different groups and analysts, in a constant and pressing communication flow. Many students tell about a time when teamwork was complex and eventually very successful and they were both leader and followers in the process.

Answer 21

Martin's example response: I'd take the one where I'm the SME (subject matter expert) and assuming that one of them is low effort high impact I'd take that one as well. For the third one I'll delegate.

Answer 22

You have never worked in finance before, what do you know about the job of an Analyst/Associate? You should acknowledge that fact, but show how much research you have carried out (including talking to friends who work in banking etc) which means you have formed a good idea of the role and believe that you would be a great fit. Then you should talk about what you understand the role to be. eg. An Associate In IBD The associate leads the execution of all the work done by the team, from the pitch to the execution of the deal as well as acting as the coordinator of the team. The main qualities/roles of an Associate: - Successfully lead and coordinate with Analysts. - Get the number rights and are technically prepared. - Have business judgment (do not waste time of analyst by working on useless things). - Have commercial skills when facing a client.

Answer 23

In an IPO the main role of banks is to guide companies in the process to raise money from equity investors on the public markets. The process is lengthy and involves many steps and different actors. Bankers are in charge of the coordination of the all process, with particular attention to the communication with potential investors. The final responsibility of the process being in time lies always on the bankers. In managing the IPO, banks have four main activities: • Coordination: - Coordination and planning of the process - Control and monitor work streams • Documentation/Listing filings: - Prospectus - Due diligence (legal, business, financial) - Legal filings - Documents/contracts (Underwriting agreement, legal opinion…) • Valuation / Equity story: - Valuation (price range) - Equity story (why the company is a good investment?) • Marketing: - Offer structure (index, size) - Communication - Roadshow/book building - Aftermarket (greenshoe, stabilisation)

Answer 24

This question is highly important, even if it is not directly asked during an interview, it can be used during your interview and is nowhere else, you can use it during the last part of your interview when the interviewer asks if you have any questions for them, thus prepare a recent deal that the bank has done. This question reflects an everyday situation in banking. Often senior bankers ask analysts and associates to scout for information on specific deals and prepare a concise summary. However, the main purpose for this question is to understand your passion about M&A and how well you followed the market. If you are applying for a specific sector you should cover that with particular attention. Summarise the deal and why you think it is interesting in few sentences. Prepare a one-page deal summary on at least 4-5 transactions. You should include the following information: - Announcement date - Acquirer and target description - Enterprise Value and Equity Value - EBITDA and PE multiples (in line with industry average? Accretive or dilutive for the buyer?) - Structure of the deal (Cash vs stock, LBO?) - Deal rationale (VERY IMPORTANT, remember what’s M&A all about) - Synergies announced at transaction - What is the impact on the industry? - Market response - Banks involved

Answer 25

Use your story and the answer to the role of an Analyst or Associate to formulate your unique answer.

Answer 26

If you played any sports it’s a good opportunity to link its particular skills with those required from an analyst/associate. Build the answer around “what makes a great analyst/associate?”

Answer 27

Again, this question is a test of your understanding of the job. Many students say that you look forward to contributing to your team and finally practicing/learning what you have been studying so hard.

Answer 28

If it is an auction, of course you want to be on the sell-side because it is more probable you’ll earn the success fee. Think of an auction where 10 buyers are in competition to buy one company. The advisors on the buy-side are going to earn the success fee only if their client ends up buying the company, while those on the sellside can sell to each one of the 10 buyers. If you had to be on the buy-side, you should prefer to be on the side of a strategic buyer, because they’re more likely to be able to pay more, since they will generate more synergies through the transaction than a financial buyer.

Answer 29

Ask for the goal of the investors. Is it a 20% return in one year or a long-term investment looking to cover your retirement needs? Build the portfolio of investments around your objective. If it is a short-term capital gain you should pick a high beta stock. Good ideas can be found from the stock pitch competition organized every year from the Investment Management club. Evaluate the investment, stating why you believe the industry is attractive and then why the company is going to be able to capture value in the industry. If the investment goal is to create returns on a 30 year time horizon, a balanced portfolio may be the best option. Use the corporate finance class to prepare better for this question, but keep in mind that recruiters are interested in your ability to understand clients’ need, respect limitations and understand why some investments are better than others. Another strategy that can really help is if you have been building on your own portfolio, this can be a real winner as you have spent time on choosing certain sectors and or companies and while doing so you have built some understanding/rationales for the same. If you have done so, you will be able to very comfortably answer this question and possibly win over the interviewer.

Answer 30

This is an obvious question if you are interviewing for an industry team. They want to test your understanding and your passion for the industry, don’t miss out on this opportunity to show your preparation. Structure your answer by addressing: • Why this trend is going to create or shift demand • How the competition in the industry is likely to change • Why M&A activity may happen as a consequence (quote a recent deal if you can) • Returns in the sector • Regulatory environment and possible changes in the near future • Major players and their returns • Future of the sector You should pick a relevant and recent trend, and be specific.

Answer 31

Recruiters want to see how well you reason about valuing an investment. In fact, if you do not sell, it means you are “investing” the lost price in the company. Therefore, from a pure financial point of view you expect the present value of future cash flows to be higher than the price offered. Of course there are other factors you would like to address, such as the cultural affinity, the governance and the fact that you may want to retain a decisional role in the company. From an evaluation point of view you should understand the future of your company and the potential business plan: • How attractive is the market? • Is the company going to capture value in the market? This will give you an estimate of the growth of the company. • At what price can the company be valued in 5 years? What’s the present value? This can be done by either looking at the intrinsic value of the company (done using DCF) or also looking at comparable public companies or even comparable transactions in the past. Also, try to get a range of an acceptable value for the company. This exercise will give you the guidelines to understand how to look at the value of your company. Then you should consider the key terms of the offer: • What’s the price vs the combination of the value of the company calculated in the previous step and the present value of the synergies the acquirer expects to realize • Payment structure (cash vs stock), for a better idea of what this means, have a look at the section on Merger Consequence Analysis. Finally draw your conclusions.

Answer 32

The value of the Assets of a company is given by the fact that owning 100% of the company will give you 100% of all the future income generated from the company. Therefore, the value on the financing side (owners of the future income) is equal to value on the assets side (you are as rich as much it’s valued what you own). Usually companies are financed through a mix of debt and equity; therefore the enterprise value is equal to the sum of the value of debt and the equity

Answer 33

Think about the case you buy a house worth $100m using $70m of Debt. After one year you decide to sell the house, which is worth now $120m, how much is the value of the equity? You receive $120m, from the sale, but you have to repay your debts for $70m, so equity is what remains after you repay debt: $120 - $70 = $50m. Here we go. Value of Assets: present value of the future income generated by the assets of the company. Value of Debt: present value of the payments to debt holders less the excess cash (Net Financial Position). Payments to interest holders include passive interests and capital repayments (think to your HSBC loan). Value of Equity: present value of payments to equity holders (if listed, share price x shares outstanding). Payments to equity holders include all the income left after having paid the debt holders. For this reason equity represents a “residual” claim on the value of the company assets. Therefore, in every valuation we will use the following equation: Enterprise Value = Equity Value + (Debt – Cash “net debt”) However, given that you are interviewing from LBS and have studied Corporate Finance, you need to come up with a more sophisticated answer to this question: Enterprise value = common equity at market value + preferred equity at market value + minority interest at market value, if any + net debt (debt at market value - cash and cash-equivalents) + unfunded pension liabilities and other debt-deemed provisions - Long term and Equity Investments – Net Operating Losses + Capital Leases • Preferred and Minority Interest are just other types of equity and thus treated just as common equity is treated • Net Operating Losses – Should be valued and arguably added in, similar to cash. • Long-Term Investments – These should be counted, similar to cash. • Equity Investments – Any investments in other companies should also be added in, similar to cash (though they might be discounted). • Capital Leases – Like debt, these have interest payments – so they should be added in like debt. • (Some) Operating Leases – Sometimes you need to convert operating leases to capital leases and add them as well. • Unfunded Pension Obligations – Sometimes these are counted as debt as well.

Answer 34

Good question, the value of an asset depends on the cash you will receive from it. But because future cash flows are risky, we have to discount them in order to account for risk and time value of money.

Answer 35

By using discount rates, which reflect the cost for the time value of money and the cost for remunerating the risk of volatility of the future cash flows.

Answer 36

Using the CAPM: Return of market portfolio = Rf + Beta (Rm – Rf) Let’s start from a basic question, what does return to equity investors compensate? It compensates for the time value of money and for the risk of the investment. • Time Value of Money: imagine a US govt T-bill which matures in 1 year. It is assumed to carry no risk (US Govt will not default), but is still offering a positive return on your investment. Why? The return offered from a T-bill (Rf) is compensating the investors for the fact that if you lend money today you will not get it back for a year. • Risk: risk arises from the standard deviation of the cash flow profile. As we have seen, a T-Bill carries no risk (standard deviation = 0), because the US government is asumed to be able to pay back the exact amount promised. However, if you are buying a market portfolio ( eg ETF on SP500), you will require a higher expected return than T-Bills since it does not offer the same certainties of return. Since there is a higher risk that you might lose money, you want to be compensated for that by receiving a greater return.

Answer 37

It all boils down to the variability (standard deviation) of cash flows, which are influenced by two kinds of risks: • Unique project risk: These are the risks associated with the fact that there are some perils which threaten the success of an individual company but not necessarily the economy in general (management, plant failure, etc.) • Market risk: These are the risks arising from the fact that there are economy wide perils which threaten all businesses (nuclear meltdown, recession, FED interest rates…)

Answer 38

If you own only one stock in your portfolio, of course the unique project risk is going to be important, but if you own more than 20 stocks, you are going to worry more about the covariance of the stocks of your portfolio (market risk). Think in the following way: if the specific risk of each stock is idiosyncratic, it means that it moves randomly. If each specific risk in your portfolio moves randomly it means that their net effect will be zero (one stock goes up and some other goes down, net effect averages zero). Therefore, for a reasonably well-diversified portfolio, only market risk matters since it influences all your stocks in the same direction. This is the risk you can’t diversify. That is why stocks have a tendency to move together, and that’s why investors are exposed to market uncertainties, no matter how many stocks they hold.

Answer 39

As we have just seen, the risk of a well-diversified portfolio depends only on the market risk of the securities included in the portfolio, in others words from the covariance of the stocks with the market portfolio. Why the market portfolio? Because market risk is by definition measured by the movement of the market portfolio (SP500 for example).

Answer 40

You simply measure how sensitive it is to market movements. The sensitivity of an asset to the market is called beta. Stock with betas greater than 1.0 tend to amplify the overall movements of the market. Stocks with betas between 0 and 1.0 tend to move in the same direction of the market, but not as far. Of course the market is the portfolio of all stocks, so it has a beta of 1.0. Example: a stock with a beta equal to 1.20 will amplify market movement by a factor of 1.2 (market movement +10%, the stock will perform +12%).

Answer 41

CAPM states that the return required by equity investors in order to invest in a stock, is a function of the market return and its sensitivity with it (remunerates only non-diversifiable risk). Required return for stock A = Rf + BetaA (Rm – Rf) Rf = Risk free Rm = Return on the market portfolio Beta A = Beta of company A

Answer 42

As easy as that, it should generate a return higher than the required return by investors. In doing so it will become a positive NPV investment and its stock price will appreciate.

Answer 43

Investors will discount expected cash flows with the required return, thus achieving a lower valuation. Stock price will go down in order to align it with the required rate of return.

Answer 44

That depends on what you want to value. A company produces Revenues through its business activities on an ongoing basis. Then it pays all the operating costs, taxes and makes important investments decisions for the future. What remains is called “unlevered” cash flow, which is not influenced by how the company is financed. However, the financing mix dictates how this cash flow is then divided among holders of rights on the company. If there is debt, debtholders have a fixed claim and get paid first. What is left goes to equity holders. So, if you discount the cash flows to debtholders using the debt discount rate, you will find the value of the debt. In the same vein, if you discount the cash flow to equity holders using the CAPM discount rate, you will find the equity value. Adding the value of debt and equity will give you the enterprise value. However, what do you derive if you discount the unlevered cash flows? You will get directly to the Enterprise Value, but of course the discounting rate will be the weighted average of the cost of debt and the cost of equity (CAPM), which is called WACC (Weighted Average Cost of capital) The formula of the WACC is: WACC = Rd (1-tc) * D/EV + Re * E/EV

Answer 45

These are the category of questions, which are derived from the formula given above, so if debt were to go up, given that it is a cheaper source of capital, WACC would go down. Now answering the second question, if tax rates were to go up, WACC would go down as the after tax cost of capital has come down. Thus, remember the formula and also reason what the effect of each component of WACC’s formula is on WACC and why.

Answer 46

Firstly, here WACC is simply the cost of equity or in other words how much should the equity sponsors be compensated for taking on the business risk of the company. The answer lies in looking at similar companies on the basis of the following criteria: • Industry • Size • Geography ….

Answer 47

The income statement provides the results of a business’ operations during a specified period of time. • Revenues: Income that arises from the sales of goods and/or services and is recorded when it’s earned. • Expenses: Commonly includes COGS, SG&A, D&A, Interests and Taxes, which are the costs a business incurred over a specified period of time to generate the Revenues reported. • Net Income = Revenues minus expenses.

Answer 48

Sales (or Revenue) is the first line item, or “top line,” on an income statement. Sales represents the total dollar amount realized by a company through the sale of its products and services during a given time period.Sales levels and trends are a key factor in determining a company’s relative positioning among its peers. All else being equal, companies with greater sales volumes tend to benefit from scale, market share, purchasing power, and lower risk profile, and are often rewarded by the market with a premium valuation relative to smaller peers. Revenue = Units Sold * Price

Answer 49

Cost of Goods Sold includes all the costs directly related to the production of products and services, such as raw materials, direct labours, plant costs.

Answer 50

Gross profit is the profit earned by a company after subtracting COGS. As such, it is a key indicator of operational efficiency and pricing power, and is usually expressed as a percentage of sales for analytical purposes. Gross Profit = Revenue – COGS Gross Profit % = Gross Profit / Revenue

Answer 51

Selling, General & Administrative Expense usually refers to all the “central” costs, and includes expenses such as salespersons' salaries and commissions, advertising and promotion, travel, office payroll and expenses, and executives' salaries.

Answer 52

EBITDA = Revenues – COGS (not including depreciations of plants) – SG&A (not including amortisation) EBITDA Margin = EBITDA / Revenue It refers to Earnings Before Interests, Taxes, Depreciation and Amortisation. It is generally considered a proxy of the operating cash flow generation of a company, but does not include change in working capital, capex, principal repayment’s and dividends. EBITDA is widely used for financial analysis and valuation and is considered a proxy for operating cash flow since it reflects the company’s total cash operating costs for producing its products and services. In addition, EBITDA serves as a fair “apples-to-apples” means of comparison among companies in the same sector because it is free from differences resulting from capital structure (i.e., interest expense), tax regime (i.e., tax expense) and accounting policy (D&A). [However, you will also find advocates who prefer using EBIT as they believe that the company’s investment in CAPEX is an indicator of the future growth of the company, and one such advocate is Warren Buffet] It is also considered a good indicator of the ability of the company to generate profits, because it measures the profitability of the company after having paid all the operating costs. However, it does not include the cost of the tangible and intangible assets which for, particular industries such as Telecom, could be significant. In these cases analysts often use EBITDA-Capex You should also remember that even EBITDA can be influenced by individual company accounting decisions (revenue recognition, unjustified rise in account receivables, etc…).

Answer 53

EBIT = Revenues – COGS (not including depreciation) – SG&A (not including amortisation) – Depreciation – Amortisation EBIT Margin = EBIT / Revenue EBIT refers to earnings before interests and taxes and is commonly referred as “operating profit”. EBIT is generally considered a proxy of the operating profitability of a company and it is independent by the capital structure (before interest). It is used to compare companies, but as it includes non-cash expenses (D&A), it can be impacted by particular accounting policies of the company. Since those policies may differ from company to company, comparability may be affected.

Answer 54

Net income (“earnings” or the “bottom line”) is the residual profit after all of a company’s expenses have been subtracted. Net income can also be viewed as the earnings available to equity holders once all of the company’s obligations have been satisfied (e.g., to suppliers, vendors, service providers, employees, utilities, lessors, lenders, state and local treasuries). Wall Street tends to view net income on a per share basis (i.e., EPS).

Answer 55

The balance sheet is a snapshot of the financial position and the economic resources of a company. • Assets: resources that a company uses to operate its business o Current Assets: assets that could reasonably be expected to be converted in cash within one year. These are important because they fund day-to-day operations. Include mainly receivables, inventory, cash & equivalents. o Long-Term Assets: assets which are not liquid, such as Plant & Equipment. • Liabilities: claims that creditors and shareholders have on company resources: o Current Liabilities: include both operational (payables) and financial obligations due within one year. o Long-Term Liabilities: include both operational (payables) and financial obligations not due within one year. Shareholders’ Equity: the book value of the equity of a company. It comprises the original “paid-in” capital plus any subsequent issues of new equity plus the retained earnings less the dividends, which “flow through” from the income statement each period

Answer 56

``` Net Income + Non Cash Expenses (D&A) - Change in Working Capital Cash from Operating Activities: Cash flows related to producing and delivering goods/services - Capital Expenditure (Capex) + Disposals - Acquisitions Cash from Investing Activities: Cash flows related to acquiring or disposing of long-term assets + Issue of Debt - Repayment of Debt + Issue of Equity - Dividends and Buy-backs Cash flows from Financing Activities: Cash flows related to obtaining cash from lenders and shareholders, and repayments of amounts borrowed. ```

Answer 57

Enterprise value is the value of the assets of the company. It reflects the discounted future cash flows to all claimants, whereas equity value reflects the discounted future cash flows only to equity holders. Since the assets side of a balance sheet must be equal to the liabilities side, we can derive that EV is equal to the value of all the financing instruments emitted by the company (ie bonds).: EV = Equity Value + Net Financial Position + Minority Interests + Preferred Stock

Answer 58

``` Equity Value (“market capitalization”) is the value represented by a given company’s basic shares outstanding plus “in-the-money” stock options, warrants and convertible securities (called fully diluted shares outstanding). It is calculated by multiplying a company’s current share price by its fully diluted shares outstanding. Equity Value = Share price * Fully Diluted Shares Outstanding ```

Answer 59

A company’s fully diluted shares are calculated by adding the number of shares represented by its in-the-money options, warrants, and convertibles securities to its basic shares outstanding. The incremental shares represented by a company’s in-the-money options and warrants are calculated in accordance with the treasury stock method (TSM). The TSM assumes that all tranches of in-the-money options and warrants are exercised at their weighted average strike price with the resulting option proceeds used to repurchase outstanding shares of stock at the company’s current share price. In-the-money options and warrants are those that have an exercise price lower than the current market price of the underlying company’s stock. As the strike price is lower than the current market price, the number of shares repurchased is less than the additional shares outstanding from exercised options. This results in a net issuance of shares, which is dilutive (ie, it increases the outstanding share count) If the CEO of a company owns 100 call options with a strike price of $18 and the current stock price is $20, the CEO will pay the strike price to the company 100*$18 = $1,800 in order to exercise these options. The company receives the money but has the obligation to give to the CEO 100 shares (which are worth $20 each). Therefore, it uses the $1,800 to buy shares on the market. $1,800/$20 = 90 shares, but it has to give to the CEO 100 shares, so it has to issue the difference: 100-90 = 10 shares, which is the addition to account for the dilution of the in-themoney options. Treasury Method (New Shares)= ((Share Price – Strike Price) / Share Price)* Number of Options

Answer 60

Preferred stock are shares with a guaranteed dividend, while common stock are not. Moreover, in case of bankruptcy, preferred stock shareholders have priority over the commons stock. As a result, they have claims on the same cash flows, but just as debt usually requires a lower cost of capital (Rd) than the cost of equity (Re) because it has a precedence on being satisfied, so preferred stock cash flows are a little safer than common and so returns will be lower than those offered to normal shareholders.

Answer 61

Minority interest occurs when one company purchases a controlling stake in another but does not acquire 100% of the Equity. Due to consolidation accounting, however, even if you acquire only 70% of a company, the acquiring company will recognize 100% of the acquired company’s assets and liabilities on its own balance sheet. Minority Interest is the line item on the balance sheet where you will net out the 30% you do not own. Let’s say LBS is listed and buys 90% of the shares of Columbia, what happens to the 10% that they did not buy? The Columbia shareholders become minority shareholders and keep their 10%.

Answer 62

Think about if from a cash flow perspective. 10% of the cash flows coming from the subsidiary are owned by minority shareholders, not regular shareholders. So you can’t have what is not yours… but it is still part of the enterprise value, which is the present value of all cash flows discounted for the appropriate WACC.

Answer 63

First of all we should define “extra cash” (keeping in mind that the industry maybe cyclical, and what is extra cash in one period may be necessary in the next). Every business requires some level of cash and working capital to run operations on a day to day basis. Anything that is not required to meet these day-to-day cash flow obligations is excess cash. If the managers have positive NPV investments they should undertake them by definition. If they do not have where to invest they should return money to stockholders via dividend or stock repurchase. They may also repay debt, but only if this would be useful to move the D/E ratio toward the optimal ration (minimise the WACC thanks to tax shield).

Answer 64

This question represents the type of questions where the interviewer is trying to test your ability to connect the three statements, so try to work with the interviewer one statement at a time. In this question, it is just the balance sheet, issuing $2bn in debt increases the assets side of $2bn of cash, but also the liabilities side for $2bn of cash. So the net effect is zero, value is $10bn.

Answer 65

If the company uses the cash raised with the debt to pay a dividend, equity goes down by $2bn. The firm value therefore remains at $10bn. Remember that the value of a company depends only on its future cash flow and the return on assets. Capital structure matters only if there is a tax shield on debt or for the present value of financial distress.

Answer 66

Enterprise Value increases by the NPV $3bn and the Investment $2bn, therefore of $5bn. New firm value is $15bn.

Answer 67

In an acquisition the buyer would “get” the cash of the company, so effectively it is paying a price minus the cash he will receive back once he becomes the owner. Theoretically, it’s not very accurate since one should only subtract the “excess cash”, the amount of cash the company has above the minimum needed to fund its operations.

Answer 68

Simply speaking, you are decreasing the amount of equity in the company by increasing the amount of debt in the company, thus the presentation of debt (cheaper source of capital and also having a tax shield) has increased and presentation of equity has decreased, thus enterprise Value increases by the PV of the tax shield generated by the new debt (please refer to the APV method of calculating the enterprise value of the company for a better understanding).

Answer 69

No, but it could be zero if the value of the assets are lower than the value of the debt. You can’t have a negative share price or a negative number of shares outstanding.

Answer 70

Yes, a company can have a negative enterprise value if the company has loads of cash.

Answer 71

Unexercised, in-the-money options represent implicit equity value that will dilute current shareholders. Theoretically, it should already be reflected in the company share’s price.

Answer 72

Enterprise Value, since it represents the present value of all the future cash flows generated by the real assets of the firm.

Answer 73

There is almost a 100% chance that you will be asked this question, so please pay extra attention to each method and also how one is different from the other. To value a company you can create a football field showing the results of main Valuation methodologies: • Discounted Cash Flows: measures the “intrinsic value” of a company by discounting to the present value all the future cash flows of the firm available to stakeholders. This can be done using the WACC or APV. • Public Comparables: measures “relative value”, looks at a group of listed peer companies to understand how the market values companies in the same business or industry along relevant metrics, such as EV/EBITDA and P/E. You might use different metrics depending on the industry. • Acquisition Comparables: Analyses which prices and multiples companies in the same business or industry have been bought and sold historically. • Accretion/Dilution analysis: it is an affordability analysis of what the acquirer can pay rather than an analysis of the value of the target. • Leveraged Buyout: indicates how much a financial sponsor should pay a company given a targeted IRR, the debt capacity of the firm and an exit hypothesis. Another two methodologies are also widely used to frame the value of a company: • Liquidation Value: Examines how much the assets of the company are worth if sold on a stand-alone basis and used in potential distressed situations. • 52 week Trading Range: if the company is listed, then market valuation is an important benchmark

Answer 74

To be honest, there exist many versions to this question; however, following is the most highly accepted answer during the recruitment season for 2012 interns: • DCF tends to give the highest valuation as this valuation is generally based on the estimates (growth) by company and for obvious reasons, every company would want to get the highest valuation and thus get the maximum price. • Acquisition comparables tend to give a higher valuation than public comparables because strategic buyers generally generate synergies in an acquisition, which will drive a higher valuation. In addition, there is also an acquisition premium to public comparables because the acquiring entity will win control of the company and will now have access to that company’s cash flows (a public shareholder can’t decide how to allocate cash flows) • Leveraged Buyout Valuation (LBO) will be driven by financing terms available in the market. • Public Comparables tends to lead to the lowest valuation

Answer 75

• DCF it is probably the best measure of the “intrinsic value” of a firm as it discounts the unlevered free cash flow of the company by its cost of capital. It takes into account the synergies, management expectations and the tax shield generated by the desired capital structure. However, DCF is extremely sensitive to changes in its assumptions, in particular on growth expectations and discount rates. Moreover, the WACC method works only if the capital structure (D/E) doesn’t change, otherwise you must use the APV method. Finally, it is “subjective” because it reflects only your view. • Public Comps have the great advantage of showing the market valuation/expectations on companies in the same business. The main disadvantage is that depends on the availability of good peers and it relies only in public information. It also does not include a control premium which would be relevant in you are trying to value the company for purposes of an acquisition. • Deal Comps show how valuation in M&A transaction for companies in the same business has evolved in the past. However it suffers of the same comparability problem of public comps, exacerbated by the often lack of information on the deal. Moreover, M&A transactions are cyclical (move in waves), tend to respond to shocks in the industry (include a strategic premium) and include synergies that are very hard to extrapolate. • Leveraged value is basically a DCF with special conditions. It gives you the value that a financial sponsor can pay given a certain business plan, an exit multiple and a targeted IRR.

Answer 76

To create a DCF valuation involves 5 steps: • First, you look at the financial statements of the target in order to derive the historical financials such as Revenue, COGS, SG&A, EBITDA, CAPEX, Change in Net Working Capital, D/E, etc. • Second, project financials (usually 5-10 years) in order to derive future cash flows available to both debtholders and shareholders (unlevered FCF) for the business plan period. There are two ways to extrapolate FCF, both give you the same result: • Third, find the right discount rate. Bankers often use the WACC, which is very convenient when you use a long-term D/E and you don’t expect the capital structure of the company to change dramatically. Where Re is the Return required by equity investors (CAPM), Rd is the cost of debt, Tc is the marginal tax rate, and D/E is the long-term capital structure for the company. If the D/E ratio is expected to change dramatically you need to use the APV method. Basically you first calculate the value of the company as if it were all equity financed (WACC = Re if there is no debt) and then you add the present value of the tax shield created by interest expense and subtract the present value of the financial distress. • Fourth, determine the Terminal value of the company, in other words the present value of all the future cash flows after the least year of projections/business plan. There are three ways to find the TV: o Gordon Growth Model (Perpetuity formula): present value at the last year of projections of an infinite series of cash flows growing at g and discounted at WACC. Perpetuity growth is obviously highly sensitive to the long-term growth assumptions, which is usually calculated between inflation and long-term GDP growth (2-5%). METHOD 1 METHOD 2 EBITDA Net Income - D&A + Interest expense * (1-Tc) EBIT + D&A - Taxes - Capex NOPLAT - Increase in Working Capital + D&A Unlevered Free Cash Flow - Capex - Increase in Working Capital Unlevered Free Cash Flow FCF (last year) * (1+g) WACC - g o Exit multiple: terminal value is most commonly calculated as a multiple of the EBITDA or EBIT in the last year of projections. Of course, a high EBITDA multiple implies high growth expectations. The multiple you use is generally based on the average multiple observed for companies of this type in the public market (ie, from your public comparables analysis) o Liquidating value in the terminal year (used for example in mining) • Fifth, obtain the Net Present Value of the company by discounting to today using the WACC the cash flows for the year of projections and the terminal value.

Answer 77

``` METHOD 1 Revenue - COGS Gross Profit - SG&A EBITDA - D&A EBIT - Taxes NOPLAT + D&A - Capex - Increase in Working Capital Unlevered Free Cash Flow - Interest expense * (1-Tc) - Principal repayments Free Cash Flow to Equity ```

Answer 78

The terminal value typically accounts for a substantial portion of a company’s value in a DCF, sometimes as much as three-quarters or more. Therefore, it is important that the company’s terminal year financial data represents a steady state level of financial performance, as opposed to a cyclical high or low. Similarly, the underlying assumptions for calculating the terminal value must be carefully examined and sensitized. The weight on the value depends mainly on: • Length of projections period before using the TV (visibility of the business) • Long-term growth rate (g) used to calculate the TV. Note that if you used the exit multiple method, your assumption would be the same. A high multiple corresponds to a high growth rate, and you can always calculate the implied perpetuity value to an exit multiple value by finding the g where the two values are equal.

Answer 79

Mathematically, (1+g) grows the last projected year out another year (to the first year of the perpetuity method). Why? The simple formula without (1+g) is: FCF / (WACC-g) says: “give me a constantly growing stream of cash flows that starts at the end of the year and I will give you the value of that cash flow stream at the beginning of the year. However, you need the present value of the cash flows to fall at the end of the last projected year, not at the beginning.

Answer 80

A business generates cash through its daily operations of supplying and selling goods and/or services. Some of the cash has to go back into the business to renew fixed assets and support working capital. If the business is doing well, it should generate cash over and above these requirements. Any extra cash is free to go to the debt and equity holders. The extra cash is the free cash flow to stakeholders.

Answer 81

Unlevered free cash flows are generated by the use of the company real assets, disregarding the company financial structure (D/E). Therefore, discounting unlevered cash flows will give you the enterprise value of the whole company. If, however, you discounted the cash flows to debt holders by the cost of debt you would be able to find the value of the Debt, while if you discount the cash flows to equity holders by the cost of equity you would be able to find the value of Equity. The unlevered free cash flow is equal to the sum of cash flow to debt holders and the cash flow to equity holders.

Answer 82

There are two ways to extrapolate FCF to equity holders, both give you the same result: ``` METHOD 2 Net Income + Interest expense * (1-Tc) + D&A - Capex - Increase in Working Capital = Unlevered Free Cash Flow - Interest expense * (1-Tc) - Principal repayments = Free Cash Flow to Equity ``` Important note: you should know both ways of calculating FCFs as the interviewer might be bored of hearing one kind and then might want you to tell him the other ways, so be prepared, this happened to me.

Answer 83

WACC is the Weighted Average Cost of Capital of a company including the tax shield generated by the taxdeductible nature of interest. It reflects the riskiness of the cash flows you are discounting and can be seen as an opportunity cost of capital or what an investor would expect to earn in an alternative investment with a similar risk profile. For example, a large utility company should have a lower cost of capital than a more risky start-up in social media. Most companies use a combination of debt and equity to finance their assets; therefore their cost of capital will be a combination of the cost of debt adjusted for the tax shield and the cost of equity. WACC is the combined, weighted cost of debt and equity: Debt Total Capital WACC = * Cost of Debt * (1-Tax Rate) + Equity Total Capital * Cost of Equity Cost of Equity = is the return required by equity investors, which is dependent by the riskiness of the cash flows (Return on Assets) and the financing mix (D/E). Cost of Debt = yield to maturity implied by the trading price of a company publicly traded debt. D/E = Long-term ratio of the company, usually in line with the industry and the long-term strategy of the management. In the absence of explicit company guidance on target capital structure, the banker examines the company’s current and historical debt-to-total capitalization ratios as well as the capitalization of its peers. Tax Rate = use the marginal tax rate, not the effective.

Answer 84

The WACC uses the after tax cost of debt because unlevered free cash flows do not include the effect of interest when you calculated taxes. However, most businesses have debt and interest payments, and the WACC picks up the tax savings from interest payments. The idea is that because interest payments are tax-deductible, the cost of debt to the firm is actually lower than the stated coupon. (p.60 LBS guide, TBC)

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