Top 16 Investment Banking Technical Questions With Answers
Are you applying for a job in investment banking? Even though going on a job interview can be scary especially when asked some of the more frequently asked technical questions during an interview, many finance and business students who are looking for entry-level positions in investment banking become unresponsive. You must be prepared to respond to some of the most typical investment banking interview questions because getting your first job interview is frequently a challenging task. Here are 16 investment banking technical questions and answers that you can expect to see in the recruitment process and might help you if you want to perform well during the interview.
Interviewers want to figure out your suitability for this respected area of banking and finance, therefore you should come prepared for your interview for your investment technical questions.
Both Freshers and Professionals Need to Have a Basic Knowledge of the Following Concepts,
- Finance Concepts
- Accounting Concepts
- Valuation Concepts
- Equity Value and Enterprise Value
- Discounted Cash Flow Concepts
- M & A and Merger Models Questions
- Leveraged Buyouts and LBO Model Questions
Investment Banking Technical Questions – Accounting Questions
Q. Explain the difference between EBIT and EBITDA.
Answer: A company’s operational success is measured by EBIT (Earnings Before Interest and Taxes) and EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization).
Both eliminate interest and taxes to concentrate on the profits from the company’s core activities, which is where they are comparable.
EBIT: Also referred to as operating income, EBIT shows a business’s profit before subtracting interest, costs, and taxes. Non-cash expenditures like depreciation and amortization, which are connected to the deterioration of assets used in the business’s activities, are taken into account by EBIT. Regardless of a company’s financial structure or tax status, it offers glimpses of its profitability from its core operations.
EBITDA: By re-adding depreciation and amortization to EBIT, this measure goes one step further. The steady deterioration of physical and intangible assets is reflected in depreciation and amortization, which are non-cash expenses.
EBITDA concentrates only on cash inflows and outflows from operations, ignoring the cost associated with capital expenditure (CapEx) such as depreciation and amortization. By adding back these charges, EBITDA offers a clearer view of the company’s operational profitability.
In conclusion, EBITDA does not account for depreciation and amortization expenses, only EBIT does. Since it is not a replacement for real cash flow analysis, EBITDA frequently serves as a proxy for operational cash flow because it tends to be greater than EBIT. Even though both measurements are helpful, they serve different objectives in financial analysis and offer somewhat different information.
Q. What is goodwill and how it is calculated?
Answer: A form of intangible asset called goodwill is produced during an acquisition and represents the worth of a business from an accounting perspective that is not accounted for by its other assets and liabilities. By deducting the equity purchase price paid for the company from the target’s book value (written up to fair market value), goodwill is calculated which is also known as the “excess purchase price”. According to accounting regulations, goodwill has to be analyzed annually for impairment rather than being amortized every period. Goodwill can stay permanently on a company’s balance sheet if it is not affected.
Investment Banking Technical Questions Related to Finance
Q. Walk me through the three financial statements.
Answer: The income statement, balance sheet, and statement of cash flow are the three financial statements.
The income statement is a document that reflects the profitability of the company. The revenue line is the starting point, while net income is the result of removing different costs. The income statement refers to a certain time frame, such as a quarter of a year.
The balance sheet is a snapshot of the business at a certain moment in time, such as the end of the quarter of the year, unlike the income statement, which accounts for the full period. The balance sheet lists the company’s assets together with the obligations and stockholder’s equity used to fund those assets. The amount of assets must always match the sum of liabilities and equity.
Last but not least, the statement of cash flows, which matches the beginning and end of the period’s cash balance, is an expanded version of the balance sheet’s cash account. In most cases, cash from operations is obtained by starting with net income and then adjusting it for different non-cash expenses and non-cash income. The cash flow from operations is then combined with the cash from investments and financing to get the net cash change for the year.
Q. If you had to choose one financial statement to value a company, what would you pick and why?
Answer: The cash flow statement is the most crucial financial statement in a company, both for valuation and any other purpose. The discounted cash flow approach, a DCF is now the most used valuation technique. The DCF consists only of discounting the company’s future cash flows and calculating the present value of each of those future cash flows. This is carried out since a firm consists only of its projected future cash flows. There is no apparent value for a company if it cannot turn a profit since it will not generate cash flows.
That’s why the cash flow statement offers an in-depth analysis of how much cash remains in the business after all types of costs. Cash flow from operating operations, cash flow from investment activities, and cash flow from investing activities are the three main parts of the cash flow statement. After all of these factors have been considered, the net cash flow is what is referred to as a free cash flow, and this serves as the foundation for all company valuation calculations.
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Investment Banking Technical Questions Related to Valuation
Q. What is Beta and how would you calculate beta for a company?
Answer: Beta is a measure of a security’s systematic risk about the overall market, or the non-diversifiable risk that cannot be mitigated by portfolio diversification.
Calculating raw betas from previous returns and even predicted betas is an imperfect measurement of future beta due to estimate flaws (i.e. standard errors generate a wide possible range for beta).
As a result, it is suggested that we make use of an industry beta. However, the betas of comparable firms tend to differ due to variable rates of leverage, we should unlevel the betas of these comparable companies as follows:
Β Unlevered = β (Levered) / [1+(Debt/Equity) (1-T)]
Then, after calculating an average unlevered β, apply this beta to the target company’s capital structure:
β Levered = β (Unlevered) x [1+(Debt/Equity) (1-T)]
Q. How would you value X company?
Answer: An X company can be valued using a variety of techniques, such as discounted cash flow analysis (DCF), comparable company analysis (Comps), and precedent transaction analysis.
An X company’s worth is determined via a DCF analysis using the predicted free cash flow’s present value.
The Comps refers to comparing the company’s value multiples with those of other similar companies.
Precedent transaction analysis determines a company’s worth based on recent M&A transactions involving businesses that are comparable to it.
Investment Banking Technical Questions Related to Equity Value and Enterprise Value
Q. How do equity value and enterprise value differ from one another?
Answer: Two types of measures are used to estimate the value of a company: Enterprise Value and Equity Value (also known as market capitalization).
The worth of a company’s equity in general can be determined by dividing the share price by the number of outstanding shares.
However, Enterprise value is a measurement of a company’s entire value, which includes cash equivalents, equity, and debt.
Q. What is Enterprise Value and how is the enterprise value calculated?
Answer: A more comprehensive method of valuing a business than the equity value (or market capitalization) is called enterprise value. Enterprise value takes account of the cash, debt, and equity of a company.
To calculate enterprise value, use the following formula:
Enterprise value = market capitalization or market value of equity (MVE) + preferred stock + minority interest + debt – cash equivalents
Investment Banking Technical Questions Related to Leveraged Buyouts and LBO Model
Q. Walk me through the steps involved in building the LBO model.
Answer:
First Step- Entry Valuation:
Calculating the implied entry valuation using the entry multiple and LTM EBITDA of the target firm is the first step in creating an LBO model.
Second Step- Sources and Uses:
The suggested transaction structure will then be shown in the “Sources and Uses” section.
The sources side will describe how the purchase will be funded, while the uses side will determine the overall amount of funds needed to accomplish the acquisition. The biggest question that has to be resolved is: How much equity must the financial sponsor contribute?
Third Step- Financial Projection:
Following the completion of the sources and uses table, the company’s free cash flows (FCFs)will be forecasted based on its operating hypotheses such as the rate of revenue growth, margins, interest rates on debt, and tax rate.
The amount of cash available for debt amortization and the annual interest expense are both determined by the FCFs generated, making them a crucial component of an LBO.
Fourth Step- Calculation of Return:
The investment’s exit assumptions are determined in the last stage, along with exit multiples and exit dates and the total funds obtained by the private equity company are utilized to calculate the IRR and cash-on-cash return, along with several sensitivity tables.
Q. In an LBO model, how is the balance sheet adjusted?
Answer: The extra debt is initially added to the liabilities and equity side, after which the shareholders’ equity is wiped out and replaced with the majority of the equity that the private equity firm is investing.
After cash on the assets side is adjusted for any cash used to fund the transaction, Goodwill and other intangibles are used as a plug to make the balance sheet balance.
Depending on the transaction, there can be further effects as well, such as adding capitalized financing expenses to the asset side.
Merger & Acquisition Questions For Investment Banking Technical Questions
Q. What differentiates Purchase Accounting from Pooling Accounting in an M&A transaction?
Answer: When using purchase accounting, the seller’s shareholders’ equity is removed, and then the excess premium is recorded as goodwill on the consolidated balance sheet after the acquisition.
Pooling accounting simply sums the two shareholders’ equity amounts rather than dealing with goodwill and the derived items.
Purchase accounting can be utilized in 99% of M&A transactions since pooling accounting has limitations.
Q. Will an all-stock merger between a low P/E company and a high P/E company likely be accretive or dilutive?
Answer: If all other factors are equal and the acquiring company’s Price to Earnings (P/E) is lower than the target’s P/E, the acquisition will reduce the acquirer’s Earning Per Share (EPS). The reason for this is that the acquirer must pay more than the market worth of its earnings for each dollar of earnings. Thus, to complete the deal, the acquirer will have to issue proportionately more shares in the transaction.
Functionally, proforma earnings – the numerator of EPS and the sum of the profits of the acquirer and the target – will rise less than the proforma share count, which will result in dilutive EPS.
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Merger Models Questions For Investment Banking Technical Questions
Q. Walk me through the steps of a merger model
Answer: The eight steps that make up a merger model are listed below:
Step 1- Determine the entire offer value by multiplying the offer price per share by the target’s fully diluted share count, including dilutive securities like options and convertible debt instruments.
Offer Value = Offer Price Per Share x Fully Diluted Shares Outstanding.
Step 2- Determine the transaction structure, specifically the acquisition consideration (Cash, Shares or a Combination)
Step 3- Several assumptions must then be made regarding the amount of interest expense, the number of new shares issued, the anticipated revenue and cost synergies, the transaction fees paid to investment banks for their advisory services, financing fees, and whether the current debt will be refinanced (Or debt free, cash free)
Step 4- Purchase Price Accounting (PPA) is the next process, where the crucial numbers to compute are goodwill, the increased depreciation from writing down PP&E, and any deferred taxes.
Step 5- Following the completion of Purchase Price Accounting, we will determine the standalone earnings before taxes (EBT).
Step 6- Next we will figure out the pro forma net income (often known as the bottom line).
Step 7- To calculate the pro forma EPS, divide the pro forma net income by the pro forma diluted shares outstanding.
Step 8- We now have enough data to use the following calculation to assess if the impact on the pro forma EPS was accretive or dilutive:
Accretive/(Dilution) = (Pro Forma EPS / Standalone EPS) – 1
Q. What are synergies and how do you incorporate them into the merger model?
Answer: In M&A, synergies refer to the projected cost savings and additional revenue that result from a merger or acquisition.
Synergies come in two varieties:
Revenue Synergies: According to revenue synergies, the merged firm can produce greater cash flows than it could if the cash flows produced on an individual basis were joined together.
Cost Synergies: Cost synergies refer to business initiatives including cost reduction, combining similar tasks, shutting unused sites, and reducing unnecessary staff jobs.
Buyers frequently use the estimated synergies from possible acquisitions as justification for charging greater purchase prices.
In M&A, synergies play a significant role in determining the acquisition price since the buyer’s control premium increases with the anticipated number of post-deal synergies.
Synergies theoretically assert that two things’ combined value is greater than the product of their components.
Once their chances for organic development have been limited, most businesses seek to aggressively participate in M&A to gain synergies.
The performance of the merged company and its future valuation, once the integration is complete, are expected to be better than the sum of the individual enterprise once the merger is closed.
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Discounted Cash Flow Concepts For Investment Banking Technical Questions
Q. Walk me through the steps of building a DCF model for a company.
Answer: The unlevered DCF technique is the most frequent form of DCF and it can be built by using the following steps:
Step 1- Forecasting Free Cash Flow to Firm (FCFF):
In the initial step, the company’s FCFFs are forecasted for a period of five to ten years.
Step 2- Determine the Terminal Value (TV):
The value of all anticipated FCFs beyond the original forecast period (i.e. the explicit forecast period) is then calculated, and the final amount is referred to as the “Terminal Value”.
Here are the two ways of calculating terminal value:
1)Growth in perpetuity approach and
2)Exit multiple approach
Step 3- Stage 1 and Stage 2 are converted to Present Value (PV):
Since a firm is valued using a DCF as the present date, both the initial forecast period (Stage 1) and terminal value (Stage 2) must be discounted to the present using a discount rate, which is the weighted average cost of capital (WACC) in unleveled DCF.
Step 4- Transition from Enterprise Value to Equity Value:
After both components have been discounted, the total of both phases equals the company’s expected enterprise value. To go from the enterprise value to the equity value, eliminate net debt and any non-equity claims.
To determine, net debt, subtract the entire amount of debt from the sum of all non-operating assets such as cash or short-term investments. Furthermore, any non-equity rights, such as minority interests, must be accounted for.
Step 5- Calculate the Implied Share Price:
To calculate the DCF-derived value per share divide the equity value by the number of shares outstanding as of the current valuation date.
However, the diluted share count should be used rather than the basic share count since any potentially dilutive instruments must be addressed.
Step 6- Sensitivity Analysis:
After determining how sensitive a DCF model is to the assumptions employed, the final step is to generate sensitivity tables along with scenario analysis to analyze how changing the assumptions affects the resultant price per share.
Q. What is the use mid-year convention in a DCF and Why?
Answer: According to the mid-year convention, expected cash flows are treated as though they were received in the middle of each month. If not, a DCF using the mid-year automatically presumes that all cash flows are received at year’s end, which is incorrect because cash flows are created throughout the year.
The mid-year convention, as a compromise, presupposes that the FCFs are received in the middle of the year.
For example, the mid-year convention would use 1.5 instead of 2, if the discount factor for cash flows in year 2 is 2, as it is expected that half a year has gone before the cash flow is created.
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Frequently Asked Questions on Investment Banking Technical Questions
Q. How to answer “Why to choose investment banking”?
You can answer this question like,
Because investment banking provides chances for ambitious people, fascinating and dedicated individuals can enter the field. The people you interact with and work with will be intelligent and enthusiastic. One of the most fulfilling aspects of working in banking is being surrounded by like-minded individuals.
Q. How important financial concept is, in an investment banking interview?
The main goal of investment banking is to meet the financial demands of the company and the investors. To make the transaction go well, the banker must arrive at financial conclusions. Here are some of the few most important terms that any interviewee for an investment banking role should be familiar with.
Financial statement terms include working capital, depreciation, enterprise value, financial ratios, such as liquidity, solvency, valuation, and profitability ratios, as well as capital budgeting, cost of capital, recent M&A transactions, and others.
Q. Do I need to focus on the accounting concept for the investment banking interview?
In an interview for investment banking, accounting questions are unavoidable as it is the foundation of investment banking. Since valuation and deal-making depend on a detailed grasp of how businesses evaluate and report their financial health you may be asked questions that call for a basic understanding of accounting.
Final Thoughts on Investment Banking Technical Questions
By extensively practicing investment banking technical questions that include, valuation, and acquisitions you can easily ace your investment banking interview. It is advised that while you read this article, you actively continue to provide your answers to the questions before confirming the proper answers. This will encourage the practice of thinking and responding to these formal inquiries.
