Beyond the guide: a list of real interview technical questions

Over the past few years, this forum has helped me a lot, so I thought I'd give back. The following questions are all from interviews and superdays I've had at various BB/EBs. I only posted technical questions that are not in the traditional guides. I come from a target b-school and did not go through diversity (gender/URM) recruiting, so my experience may differ from many of you. Regardless, I hope these help.

 

1. Rank EV/EBITDA, P/E, and EV/EBIT for the "general" company.

2. How would you value NOLs?

3. You sell a subscription that is $12 per year, delivered monthly.

3a. Walk me through the 3 statements right after you sell the subscription (the $12 is delivered at the beginning of the year all at once).

3b. Walk me through the 3 statements after one month.

4. What kind of company would have the same EBITDA and Net Income.

5. A company acquires $200 worth of PP&E.

5a. Walk me through the 3 statements for each of the following variations: 1) 100% cash purchase; 2) Operating Lease; 3) Capital Lease

5b. Rank each of the aforementioned variations in terms of EBITDA, Net Income and EBIT.

6. Why might two companies with the same financial profile have different EV/EBITDA multiples?

7. What's the relationship between the D/E ratio and WACC?

7a. What's the relationship between the D/E ratio and the value of a company?

8. How does an increase in the tax rate affect the value of a company?

9. A company has an EV of $100, no cash and $400 of debt. How is this possible?

10. How much would you pay for an asset that pays you $100 a year, guaranteed?

11a. There is a company that manufactures pots from steel. The company purchases $500 of manufacturing equipment and $500 of steel financed by $1000 of debt. The company has a 10% cost of debt with no debt amortization and depreciates its manufacturing equipment using straight line depreciation over 5 years with no residual value. Walk me through the 3 statements right after the purchase.

11b. Say the company sells $900 of pots and uses $300 of its steel. It has $200 in SG&A expense and has a 40% tax rate. Walk me through the 3 statements at the end of Year 1. 11c. Say the company switches to FIFO accounting from LIFO and that the price of steel is declining. What happens to the company’s free cash flows and what happens to the value of the company?

12. A company has a $100 market capitalization. There are 100 options with strike price of $5. Current share price is $10. What’s the fully diluted market capitalization?

13. If you buy a company trading at 20x P/E and the deal is financed 100% with debt at 5% interest, is the deal accretive or dilutive?

14. Does mid-year convention result in a higher or lower valuation?

15. What are some pros/cons of a strategic and financial acquirer from the perspective of the target company?

 

 

 

Les,

Perhaps you mentioned this already, but for my own edification, what type of position(s) are you interviewing for where you were asked these technical questions?

There were several questions you listed that are pretty nebulous in nature and would seem to require additional information to be able to answer the question properly. For instance, 11c asks about changing accounting methods from FIFO to LIFO and asks about the impact of the companies FCF. Perhaps I'm oversimplifying this, but doesn't the valuation of the shares purchased by the company at specific intervals throughout the fiscal year have an impact as to whether the shares liquidated (regardless of FIFO or LIFO) increase/decrease FCF?

 

These were interviews/superdays for investment banking SA positions.

You are right--some of the questions require some assumptions to be made. Like for #5, you would probably need to make an assumption about the depreciation rate, but that is something you can ask the interviewer for. Many of my interviewers intentionally left out some piece of key information to test whether or not I would ask for it or make an assumption.

By "shares" do you mean inventory of steel? Not sure what you're asking here.

 
Best Response

I'll bite. Feel free to correct me if I'm wrong on any of these...

  1. From highest to lowest: P/E, EV/EBIT, EV/EBITDA (generally, obviously depends on amount of debt of the company and differences between EBITDA and net income)

  2. This one is iffy. I've heard 30 different ways to value an NOL. Generally you value it separately from the operations of the firm. So you would look at your projections, and offset taxable income from your projections with the NOL balance. Do this until the NOL has run out, and then discount the tax savings to PV. Again, discount rate differs depending on who you ask, but you could argue Cost of Equity as the discount rate since the NOL savings offset taxable income, which is after interest in the payment priority (i.e. tax savings flow directly to equity holders).

3.a. No change to the income statement; Cash goes up 12 on the balance sheet, Liabilities go up 12 from unearned revenue; Cash flow statement increases CFO by 12 from the increase in NWC (the liability increase from the unearned revenue)

3.b. Revenue increases by 1 (I'm just going to ignore COGS since no detail was given), Net Income increases by .6 (assuming 40% tax rate) on Income Statement; Balance Sheet: Cash decreases by .4 from the taxes you paid (Assets down .4), unearned revenue liability decreases by 1 (Liabilities down 1), Net Income increases by .6 (Equity up .6); Cash Flow: Net Income up .6, NWC change down 1 (the decrease in the unearned revenue liability), so CFO down .4

  1. This is a weird question. I suppose a company without debt (so no interest), no owned PPE (so no D&A), and has no taxable income. So some type of services company (i.e. consulting?) that isn't doing well so their EBT is 0?

5.a.1 No change to income statement; PPE increases 200, cash decreases 200, so assets net to no change; Cash Flow Statement: CFI decreases by 200 5.a.2 No change to income statement initially (although you will record rent expense during the lease period and the associated tax savings); No change to B/S initially (but will decrease cash as payments are made and change Equity as NI decreases); No change to CFS initially, but CFO will decrease as payments are made 5.a.3 No change initially to I/S or CFS; Balance sheet Asset will increase by PV of the lease payments, Liability will increase by the PV of the lease payments. As payments are made, you record depreciation and interest on the I/S, decrease the asset by depreciation, and decrease the liability as payments are made. CFS changes for CFO as interest payments are made (CFO), add back depreciation (CFO since non-cash). 5.b. EBITDA: Cash, Capital Lease, Operating Lease Net Income: Cash, Capital Lease, Operating Lease (In the early years, interest is higher, so Operating Lease and Capital Lease should be switched, but in the out years it looks like this) EBIT: Cash, Capital Lease, Operating Lease

  1. Different growth profiles, one uses operating vs. capital lease, one is an industry leader and deserves higher multiple

  2. As D/E increases, generally WACC will decrease since debt is cheaper than equity 7.a. As D/E increases and WACC decreases, value should increase *NOTE: If D/E gets too high, then debt becomes expensive/risky, so the above answers only hold true to a point.

  3. Generally decreases value, since the increased tax payments means less unlevered free cash flow. However, this can be mitigated by a lower WACC, but generally speaking value should decrease as a whole.

  4. Company is balance sheet insolvent. Debt will likely trade at a huge discount--company is distressed (theoretically speaking, equity is negative $300m, but equity can never trade lower than zero)

  5. Formula for a perpetuity is 100/discount rate. So assuming a current interest rate of 1%, I would pay $10,000. Theoretically I could take $10,000 and invest it at 1% interest to get $100 per year. *I'd also note that this assumes I live forever, but in reality I wouldn't pay 10,000 since I won't get cash flow infinitely

11.a. No change to I/S. CFS: CFI down 1,000, CFF up 1,000; B/S: Assets up 1,000, Liabilities up 1,000 11.b. Rev up $900, $300 of COGS, $200 of SG&A, $100 of dep. expense, $100 of interest exp. So $200 of taxable income, but then $80 of tax (40% tax rate), so net income increases by $120. CFS: NI up $120, add back $100 of depreciation, so CFO up $220 and net cash up $220. B/S: Cash up 220, PPE up 900 (1,000 less 100 of dep.), Liabilities up $1,000, Equity up 120 (net income). 11.c. COGS decreases, so net income increases. That said, I think value will actually decrease, since any increase in Free Cash Flow from lower COGS is tax affected, whereas the corresponding change in NWC (from inventory changes) will change by the same amount, but not tax affected. So therefore free cash flow will actually decrease, as will value. I could be wrong here.

  1. Using treasury stock method, a company will have $500 from the exercised options ($5 per share strike price x 100 options). They can buy back 50 shares ($500 / $10 per share current price). So 50 new shares issued at a current price of $10 per share means $500 of additional market cap. So $600

  2. Accretive. If you reverse the P/E, you get a cost of earnings (earnings yield) of 1/20 or 5%. This is the cost of debt, but you need to take into account the tax shield on debt, which at a 40% tax rate means an effective 3% cost of debt. So therefore you’re effectively paying 3% for earnings generating 5%.

  3. Higher valuation, since you now assume cash flows come 6 months into the year instead of 12 (so cash flows coming sooner means less discounting).

  4. Pros of Strategic: Synergies and ability to pay in stock, so upside potential for target, can generally pay more (due to synergies), operational expertise in sector Cons of Strategic: Potential regulatory approval (FTC), may only want to pay in stock if its overvalued

Pros of Financial: Higher transaction certainty (financial buyers execute many more transaction), maybe general operational expertise (running businesses in general), will pay in cash Cons of Financial: Little to no upside for target (other than maybe a MIP), might fire management, generally pay less than strategic.

 

I got mostly the same answers, with some exceptions (let me know if you agree/disagree):

For #6: This would probably be something to clarify in the interview, but similar financial profiles also means similar margin and growth profiles. In such a case, EV/EBITDA multiples might differ as a result of one-time events. Perhaps one company just got a bid to be acquired at a 20% premium. Perhaps there was a legal settlement, etc. Agree with the industry/market leader explanation, though.

For #9: We pretty much agree here. Theoretically, market capitalization (market value of equity) can never be lower than zero. Equity value is not negative $300--it is $0. The trick to this question was to recognize enterprise value is the market value of a company's operating assets. The "debt" component of EV is therefore the market value (instead of the face value) of debt. In this case, the company is clearly distressed.

For #11c: Value should be unaffected here. If value is based on a company's fundamentals (ie. real cash flows), then accounting gimmicks should not affect intrinsic value. You are correct that FCF will decrease, but overall value remains unchanged since a deferred tax asset is created, which has a value that offsets the loss in value from lower FCFs. Perhaps the question is poorly worded or unclear, but the change from FIFO to LIFO reflects a change in the company's book statements while its tax statements (what it actually pays the IRS) remains the same.

 

Yeah I agree with everything you wrote. I was thinking of the LIFO/FIFO question more from a “I’m going to do a DCF or EBITDA multiple calculation” perspective, but theoretically you’re correct in that an accounting gimmick should have no affect on value if it doesn’t affect taxes being paid.

As for the cash flows, you’re right on the free cash flow not changing—I forgot about the deferred tax component.

 

Any reason why on Q11b you didn't include include the effects on inventory given that the steel is a raw material?

For example, did the same as you on the IS but under CFO, inventory is down $300 so it's a source of cash which increases your cash flow alongside depreciation, resulting in an ending cash balance of $520.

Then on the balance sheet, PP&E down $100, inventory down $300 so net assets of $120, which balances with the $120 equity figure.

 

For number 9, equity value can never be negative. Company likely has equity interests in another company/assets worth $300, which would be treated like cash in terms of calculating EV.

The whole distressed explanation you have above is just overcomplicating it imo

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For number 10....why are you using a 1% interest rate? I would use a 5% interest rate and only pay $2,000 for a $100/yr annuity.

I am assuming that this $100 / year is a true annuity and you can NEVER get your principal back.

30yr US Treasuries are yielding 3.21% right now and you get the principal back after 30 years (with a new issue purchase).

 

Thanks Alt E S ------ very helpful answers. Would suggest a revision to your NOL. My take is that the Discount Rate would equal WACC because debt-free pre-tax income is used to value NOLs (or it was the last time I completed a valuation of one in 2010 - a lot could have changed, and my experience is with GAAP Fair Value).
At the time (again, ages ago), EITF 02-13 required consideration of stock vs asset sale in a hypothetical sale of the subject when deciding how much of the NOL is acquired.
Hypothetical Summary of the Valuation: NOLs Acquired = 20,000 Yr 2 Pretax Income = 2,919 Yr 2-Max NOL/Yr = 1,364 Yr 2 NOL Used = 1,555 Then discount Yr 2-x at WACC to estimate FV of NOL.

Following is my narrative for the Auditors: "Issue 1 Requires that management determine if the fair value of the reporting unit should be estimated based on how market participants would structure the hypothetical sales transaction of the GSE Core business. One of our most desirable assets as a Company, to a prospective buyer, would be our net operating loss carryforwards. As of 12/31/10 GSE had $15.9 million of NOL's. Management has indicated that they believe GSE would mostly likely be purchased in a stock sale because the purchaser would acquire all the NOL's. For this reason alone, management believes that a stock sale (nontaxable) would be more likely to occur than an asset sale (taxable). Therefore, it is assumed that the tax attributes of GSE will be carried forward.

According to EITF 02-13, there are three factors to consider in this regard: 1. Is the assumption consistent with what market participants incorporate in their estimates of fair value. Management has indicated that the assumption that a stock sale would occur as a result of the NOL balance is consistent in this regard. Further, our search of public companies acquired with SIC Codes 7372, 73 & 74, in 2010 indicates that 100% of the transactions were stock deals. One problem with looking at market participant transactions is that the review is focused on tax attributes of the potential buyers, not the sellers, nonetheless, we find the MA data to be compelling evidence.
2. Feasibility of the Assumed Structure: Management has indicated that the stock sale structure seems feasible and we have not explored whether there are any laws, regulations or other corporate governance requirements that could limit a non-taxable sale.
3. Whether the assumed structure results in the highest economic value to the seller, including consideration of the tax implications. Our understanding is that this factor was not analyzed by management."

 

For 11c, given that prices have declined over the period, the effect of switching from LIFO to FIFO is to reduce Net Income and increase cash flow.

From a valuation perspective, at least theoretically (and assuming no daylight between GAAP and cash taxes), switching to FIFO (ie, increasing COGS) lets you defer paying cash taxes. So this increases value.

but obviously if your cash taxes are unaffected, valuation is unaffected.

 

Sports teams are valued using revenue multiples. Except for some NFL teams, sports team values reject economic reality. 20 of the NBA teams are losing money, but I doubt they're worthless. Sports teams typically trade between 1x(think Arena Football and Soccer) and 5x(think NFL), NBA, MLB, and NHL are in the middle.

I'm swamped at work but if nobody answers the other questions I'll circle back and chime in.

 

1) need to use a multiple thats pre interest payments. so ev/ebitda is one, ev/ebit, etc 4)compare public comps rev multiples to private companys rev and apply higher one depending on growth prospects. 5) could be because of different capital structures (one has more debt). but if same risk assumes same cap strcuture, then maybe because of exposure to certain verticals that may be weak or geo regions that may be seeing weakness 6)IS and CF. if just one, then IS

 
  1. There is really no such thing as 100% debt. The equity acts as a residual claimant, and as such acts like an option on the fund's assets with the debt representing the "strike price". This is a capital structure question, so just note the failures in Modigliani Miller. You can use enterprise value multiples to compare them, and then adjust for interest tax-credits, etc. It's not really a very good question as phrased. I would just ask people directly what the failings in Modigliani Miller are.

  2. You are reliant on assumptions regarding the perpetual growth rate.

  3. Just like how you would value any other asset, estimate future cash flows and discount accordingly. There's a bunch of industry specific stuff you can use, like CBAs, projected popularity of the sport, etc.

  4. This is a stupid question. How are you supposed to value a financial asset without estimating cash flows (I'm assuming when you say no DCF you mean no variants of it, even comparables are a rough, quick and easy way to do DCF)? I'm assuming that by comparables you mean private comparables too, so stocktwo50's answer does not apply...

  5. Cap structure...i don't think it's anything else because that would be captured in risk and growth stuff...again, a poorly worded question

  6. Agree, IS and CF are most important, with IS moreso

 

4) How about comparable transactions? Is that legit, or do we consider that falling under "comparable companies?"

Its very rough, but you can just check general transaction multiples for any companies of a similar cap size or EBITDA generation, though not necessarily "comparable." Then apply those multiples to your firm

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What are the 3 financial statements?

What are the major valuation methodologies?

How do you calculate a WACC?

In a DCF, how do you calculate FCF?

What does EBITDA stand for?

What is a better investment, a company with a higher or lower P/E?

All of these depend on what you say your strengths and experience are. I have had interviews with English majors who I asked one question and left it alone because they obviously knew nothing. On the other hand, I have asked nitty gritty questions on why CAPM is a reasonable methodology for finding equity cost of capital to finance majors who claim they know these sorts of things.

Make sure you can answer anything that you say you can on your resume, and preface anything you can't well.

--There are stupid questions, so think first.
 

i've also been asked:

-why would 2 firms want to merge?

-what are the components of a pitch book?

-general and specific market questions regarding current news

-pitch me a stock

-if i was given $1,000,000, how would I invest it and why?

 

First question. 1. Cost is too high (ie one party thinks they should get more) 2. No clear synergies 3. Should Staples and McDonalds merge?

Second. Depends on industry.

Third. Using DCF? Well when you project the future revenue, will it eventually become positive or do you mean its negative "in the long run"?

Fourth. Dunno.

 
StreetLuck:
RobertSmith:
- Can you calculate comps with negative EBITDA?
If projected EBITDA is negative, go higher up the income statement to find valid multiples. Revenue multiples, perhaps?

That's the only way I could think of it. Anybody else?

 

Although I passed my interviews knowing the hallowed "Vault 4", I heard there are actually 6 standard valuation methods. Anyone know all 6?

 

Yes you record a gain of 50. The number would be different if taxes are considered, but still principally the same. Realized Value- Book Value= Gain (or loss) ignoring taxes.

 

Your accounting entries one can't be answered from the info you give - presuming you get cash for the PPE and then pay off the loan note:

Cr. PPE 50 (net effect - you would actually have a Dr. to accumulated depreciation and a Cr. to PPE cost)

Dr. Cash 50 Dr. Loan Note 50

Cr. Gain 50 (P&L impact if current year)

Blacksheeps entries are somewhat confusing because surely you need cash to pay the loan note... therefore you can't increase cvash by 100 and still pay off the note....

From the ghetto....

From the ghetto....
 

Essentially there are 6 methods which can be divided into three groups.

1) Real Options Theory (used for mining and commodity companies where the option to defer production is is a major asset) 2) Cash Flow (Free Cash Flow to Equity, Dividend Discount Model, Discounted Cash Flow, Economic Value Added) 3) Comps (P/E rations, P/S ratios, regression analysis involving multiple ratios) - used for finding relative value and where a firm isn't making any money.

Companies shouldn't merge

  • When the synergies are negative or outweighed by the transaction costs.
  • When the company is unlikely to get merger approval.
  • When the share price of the target company is overvalued.

Hostile takeovers and those involving cash rather than stock tend to have a better track record than friendly mergers.