Thursday, July 17, 2008

Guide To Technical Questions In Investment Banking Interviews

One topic everyone asks me about is how to answer technical questions in investment banking interviews. What should you expect, how do you keep your calm, and what do you do to prepare beforehand?

I actually think people tend to focus too much on technical questions when preparing for interviews. Your fit and enthusiasm for the job are much more important.

That said, if you have some previous finance experience or have studied economics or finance in school, it is important to get these questions right.

There are 3 types of technical questions you may be asked: 1) Valuation/Modeling Questions 2) Accounting Questions and 3) Brain Teasers.

You should know the three main valuation methodologies and be able to explain them to your interviewers.

First is comparable company analysis - looking at publicly traded companies and the multiples they trade at, then applying those to the company in question. This depends very much on "market data" to value companies, and the main downside is that sometimes there are no true comparable companies to use.

Second is precedent transaction analysis - looking at what buyers paid for sellers in similar industries and with similar financial profiles and applying the multiples to your own company. Again, there are often no true comparable transactions. Precedent transaction analysis also tends to produce the the highest valuations because of the control premium required to acquire companies.

Finally, there is the Discounted Cash Flow Analysis - using a company's projected cash flows, discounting them for the time-value of money and cost of capital and summing those to find the company's present value. This is the "purest" way of valuing a company since it depends solely on its financial performance, but the drawback is that it depends heavily on future projections, which tend to be unreliable.

Know these methodologies and the various advantages and disadvantages of each.

Modeling Questions
The most likely financial modeling questions you'll get will concern merger models (when a company acquires another company) and Leveraged Buyout, or LBO models - when a private equity firm buys a company using equity and debt.

The most important part of a merger model is the accretion/dilution - will a company have a higher or lower earnings per share (EPS) after acquiring another company? A merger model is an analysis of the trade-offs between using cash, stock, or debt to finance an acquisition. Any of these methods, or any combinations, will result in a different EPS. Beyond just the EPS impact, you also have to consider how much debt the buyer can afford, how much cash they have, and how much stock they can issue.

In an LBO model, you're trying to solve for the private equity firm's return on investment - the IRR. It's very similar to buying a house with a mortgage - there is a down payment (the equity part of an LBO) and the mortgage (the debt used to finance an LBO). The model measures how much the company's value grows and how much debt is paid off over 3 to 5 years. The most important drivers are purchase price, exit price, amount of debt used, and the company's growth rate and profitability.

Accounting Questions
Make sure you know the three financial statements - the income statement, balance sheet and cash flow statement - link together and be able to walk through how changes to one of them will affect the others.

One common question here is how an increase of $10 in depreciation will affect all the statements.
On the income statement, depreciation is an expense so operating income would decline by $10. With a tax rate of 40%, net income would drop by $6.

On the cash flow statement, net income is down by $6 but depreciation - one of the "addbacks" - increases by $10, so cash flow from operations would increase by $4.

On the balance sheet, Net PP&E would decrease by $10 because of the depreciation, while cash would be up by $4 from the tax savings. The $6 decrease in net income would also cause retained earnings to decrease by $6, so that the balance sheet balances - both assets and liabilities / shareholders' equity are now lower by $6.

Brain Teasers
It's hard to give a detailed overview of brain teasers because questions are usually completely different. In general, though, you want to keep your calm and focus on your thought process rather than getting the answer exactly right. Brain teasers are really just stress tests, so keep that in mind as you go through interviews.

Ian Spellfield, a former investment banker, advises students and young professionals on
understanding investment banking and how to ace their investment banking interviews.

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