What To Know for an Investment Banking Interview

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Nailing the Investment Banking Interview

Many business students want to land an entry-level job in investment banking, but they freeze during the interview when asked some of the more common technical questions. Getting the first interview is often a difficult task all on its own, so you need to be ready to answer some of the most common investment banking interview questions. For example, can you answer the following?

1. What are the ways of valuing a company?
2. What are the advantages of raising funds through bonds rather than equity?
3. What happens to various figures in a financial statement if $100 is added to the current depreciation account?

If you don’t have a ready answer for questions like these, you need to do more preparation before your job interview. Read on to learn the answers to these common questions, and what to know about investment banking before you sit down with a potential employer.

Understand the Entry-Level Job

Nothing is more offensive to an interviewer than a candidate who comes in not knowing anything about the position. Showing that you understand not only the general practices of investment banking but also your specific duties, should provide a competitive edge. After all, first-year analysts do not pitch deals to CEOs or publish research reports about hot stocks/sectors.

An entry-level position mainly involves creating presentations, compiling comp tables, and making pitch books. Although financial modeling and financial statement analyses are the bread and butter of the investment banking profession, don’t go into an interview with the presumption that you will perform such tasks on your first day on the job.

Financial Knowledge

Basic knowledge of financial statements and a general understanding of how the balance sheet, income statement, and cash flow statement are interrelated is another common technical skill-testing question of the investment banking interview. Familiarize yourself with how changes made to one section alter the figures in the other sections. It is important to understand—not just memorize—the connections between the statements.

Here is a typical example. Assuming a tax rate of 30%, if depreciation increases by $100 and pretax income decreased by $100, the following will occur:

• Taxes will decrease by $30 ($100 * 30%)
• Net income (NI) will decrease by $70 ($100 * (1 – 30%))
• Cash flow from operations will increase by the amount of the tax deduction

This causes a $30 increase of cash on the balance sheet, a $100 reduction in PP&E due to the depreciation, and a $70 reduction in retained earnings. Make sure you can easily follow this example and track the effects of any such similar adjustments. Here are some others to know.

Key Takeaways

• Preparing for an investment banking interview requires a lot of preparation. Before going into an interview, research the particular bank, familiarize yourself with the deals it has done in the past or is currently working on, and be prepared to talk about the economy and financial markets.
• In addition, refresh your quantitative skills and study common financial equations: know how to read balance sheets, income statements, and how to calculate corporate valuations.
• Since investment banking involves helping companies issue equity and debt, familiarity with these concepts is also fairly important.

Corporate Valuation: Discounted Cash Flows

Questions regarding company valuation are essential to the interview process, as this task is the basis of a banker’s everyday activities. There are three basic techniques to value a company: discounted cash flows (DCF), the multiples approach, and comparable transactions. Only the first two are likely to be discussed.

Discounted cash flows, as the name suggests, involves creating a forecast of the free cash flows (FCF) of a company and then discounting them by the weighted average cost of capital (WACC). Here’s how to calculate free cash flows:

EBIT* (1-Tax Rate) + Depreciation and Amortization – Capital Expenditures – Increases in Net Working Capital (NWC)

WACC is calculated by taking the percentage of debt, equity, and preferred shares of total firm value and multiplying the individual components by the required rate of return on that security. The terminal value of the project must also be determined and discounted accordingly.

WACC = R_e * (E / V) + R_d * (D / V) * (1-Tax)

Where R_e = cost of equity, R_d = cost of debt, V = E + D = total market value of the firm’s financing (debt plus equity) and Tax = corporate tax rate.

The WACC DCF approach assumes that the firm is levered, with the cost of debt being reflected in the denominator of the calculation. The adjusted present value (APV) approach of valuation is somewhat similar, but calculates the value of an all-equity (unlevered) firm and then adds the effects of debt at the end. This type of methodology is implemented when the company adopts a complex debt structure such as a leveraged buyout (LBO), or when the financing conditions change throughout the life of the project.

First, cash flows are discounted by the cost of equity, followed by determining the tax benefits of debt by discounting the after-tax interest payments by the fixed income required rate of return.

NPV = Value of All-Equity Firm + Present Value of Financing Effects

Theoretically, the NPV for the WACC and APV methods should produce the same final result. (For more, see Investors Need a Good WACC.)

Corporate Valuation: Multiples

The multiples method of valuation involves metrics similar to the P/E ratio. Basically, to perform a multiples analysis, one would have to determine the average multiples for the specific industry and multiply this value by the denominator for that multiple for the company under consideration.

Using the P/E ratio as an example, if an investment banker is trying to perform a valuation of a firm in the grocery store business, the first step would be to determine the average P/E ratio in that sector. This can be done by looking at comp tables, which are easily available through the Bloomberg terminal.

Next, the average value should be multiplied by the company’s EPS. If the average price-to-earnings ratio in the sector is 12, and the EPS for the particular company is $2, then the shares are worth $24 each. Taking the product of this value and the total number of shares outstanding provides the firm’s market capitalization.

The preceding example used the P/E ratio to illustrate the general premise because most people are familiar with such a measure. However, using this ratio to perform the valuation is actually incorrect; the resulting figure gives the value of the equity of the firm, ignoring debt. Although different sectors have industry-specific multiples, which should be researched prior to the interview, one of the most common multiples is the enterprise multiple (EV/EBITDA).

Enterprise value is calculated as:

Market Cap + Debt + Minority Interests + Preferred Shares – Total Cash & Cash Equivalents

This value reflects the entire value of the firm. Since the acquirer in a merger would assume the debt and other financial positions of the target, EV captures the full comprehensive value of the corporation. Furthermore, EBITDA is used in the calculation rather than just earnings for similar reasons. EV/EBITDA provides a comprehensive measure of the real value of the entire firm, which P/E fails to capture.

However, it should be noted that revenue multiples are usually not a preferred method of valuation, because revenue can often be easily manipulated through accounting practices.

Differentiating Debt or Equity

Since investment banking involves helping companies issue equity and debt, familiarity with these concepts is fairly important. Increasing the level of debt in a firm’s capital structure presents many benefits. Most importantly, since interest payments are tax-deductible, debt is considered the cheaper form of financing (you should commit this to memory).

Issuing bonds has further advantages in that the equity positions of current shareholders do not become diluted and because debt holders have first dibs on the firm’s assets in case of bankruptcy. This is also why bondholders require a smaller return on their investments.

On the other hand, increasing the amount of leverage entails higher interest payments, which could push the company toward bankruptcy during poor economic times. In contrast to dividends, which are not guaranteed, corporations are required to meet their debt agreements.

Also, as suggested by the second proposition of the Modigliani-Miller theorem, as the debt-to-equity ratio (D/E) of a firm increases, so does the cost of equity and additional debt. An optimal capital structure must be reached which maximizes the total value of the firm.

The Bottom Line

Most candidates selected for an interview should be very familiar with the presented material. Being able to discuss this information will not make you stand out as a candidate, but will merely exhibit that you understand the basics of the job. Before going into an interview, research the particular bank, familiarize yourself with the deals it has done in the past or is currently working on, and be prepared to talk about the economy and financial markets.

Rest assured, other candidates will be equally prepared, and sometimes determining who gets the job comes down to the smallest differences between candidates. In such a competitive environment, preparation and confidence are the keys to getting the job.

Read the original article on Investopedia.