Breaking Into Wall Street – Investment Banking Interview Guide

Sample Technical Interview #2 – More Advanced

Narrator: In this sample investment banking interview, we’ll take a look at some more
advanced technical questions you might receive.

In this example, the interviewee has had an investment banking internship the previous
summer – which means that the bar for technical questions will be set higher, and that the
interviewer will focus on more advanced questions and what the interviewee did during his
internship.

They’ll assume that you know the basics – so they’ll go into more complex questions and less
common scenarios.

As with the other sample interviews, this interviewee’s performance is solid, but could use
improvement in several areas – especially his “story” in the beginning, which often goes
overlooked.

Now, let’s move into the interview.

Interviewer: Ok, Will, nice to meet you today, glad you could make it here. I have your resume
in front of me but I haven’t had a chance to go through it in detail yet – maybe you can get
started by just taking a few minutes and walking me through your resume?

Interviewee: Yeah, absolutely. So just to give some background, I grew up always being
interested in sports – baseball, basketball, football, you name it, whatever sport it was, I was
always interested in it. And what really fascinated me about sports was not only the games and
the players themselves, but also all the drama that occurs when people hop between different
teams, and the contract negotiations and all the things that go into the business side of sports.

So I was really interested in business and negotiation from a very young age, particularly in the
realm of sports.

And at the same time, I was also very interested in math and quantitative research, and since I
had spent most of my youth on the West Coast, I decided to attend Harvard, primarily due to
the reputation – obviously it’s probably known as one of the top colleges in the nation for both
business and math – and in addition to that, because I wanted to explore the other side of the
country.

While I was at Harvard, I focused on my math studies and research for my first couple years.
Eventually I realized I wanted to pursue my original interest in sports and contract

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negotiations, and had some thoughts of becoming an agent for some local athletes who might
potentially turn pro.

But I soon realized that becoming an agent is harder than one usually thinks – so in the
meantime I did an internship at Citigroup, working in their wealth management group and
advising high net-worth clients. I had a really unique experience there since we were really
under-staffed at the time, so I had a lot of hands-on client contact. At Citigroup I learned quite
a bit, but I realized I was still pretty far from my original interest – and I wanted to learn more
about deal-making and how companies make decisions instead.

So the next summer, I worked at Morgan Stanley’s Investment Banking Division in New York,
where I just had a tremendous experience in light of everything going on in the market these
days. I worked on several M&A deals as well as IPO deals and a few client-service projects.
I’m here today basically because I enjoyed my internship at Morgan Stanley so much, and I
realized I’d rather focus on M&A as opposed to being in the Generalist Analyst pool so that I
can really sharpen my technical skills and learn more about deal negotiations.

Interviewer: Great, well that’s definitely some very impressive experience you have there. And
I’m sure working at a place like that during the summer has given you a lot of technical
knowledge.

So let’s just get started first with a few questions on a few basic topics.

Interviewee: Sounds good.

Interviewer: First, I’m going to assume here that you have some basic accounting knowledge
since you had all that experience working at those different places. So I want to go a little bit
beyond that and move into a bit of a more real-world, advanced scenario here.

So I want to look at specifically a scenario that can happen with companies and how that affects
the 3 financial statements. So let’s say that we’re working with Apple – just because everyone’s
familiar with Apple, the iPod, everything like that. And they raise $100 of debt so they can
purchase $100 worth of iPod inventory – and they then go and manufacture and sell that
inventory for $200 in revenue, at a cost of $100.

And I want to take this scenario and go through the 3 financial statements, and look at how
they’re impacted by each step of the process. So let’s divide this into 2 steps to make it easier to
think about and walk through – so step 1 will be the purchase of the actual inventory, so raising
the $100 of debt to get the $100 worth of inventory. And then step 2 will be actually where they
go in and manufacture and sell the iPod products.

Can you start by just walking me through what happens on the 3 statements after step 1? So
this is after they’ve raised the debt to purchase the inventory.

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Interviewee: Ok. So, just to confirm here, we have $100 of debt and $100 worth of inventory?

Interviewer: That’s correct, yes.

Interviewee: Ok, so the Assets side of the Balance Sheet would obviously go up by $100 due to
the new Inventory, and the Liabilities & Shareholders’ Equity side, or rather just specifically the
Liabilities section, would go up by $100 due to the new Debt.

And on the Cash Flow Statement, there would be $100 less of Cash Flow from Operations due
to the Inventory rising, and that would be canceled out by the new Debt, so there would be no
difference in the Net Change in Cash.

Interviewer: Ok, good. And you mentioned the changes on the Balance Sheet and Cash Flow
Statement there from raising the debt to purchase this new inventory – would the Income
Statement be affected by this new expense at all?

Interviewee: No, because expenses are only recorded when the goods themselves are actually
sold.

Interviewer: Good, and I have to tell you that you’re actually one of the few people I’ve heard
get that part of it right. A lot of people mistakenly think that purchasing something like
Inventory or Plants, Property & Equipment will show up on the Income Statement somehow.
So good job on that part.

Now let’s go through step 2 here – which is when they sell the iPods for $200 in revenue at the
expense of $100, as I mentioned before. And for purposes of this, one thing I think I forgot to
mention before – we’ll just assume that the tax rate is 40%, which is pretty much the standard,
at least for US-based companies.

Again, the scenario is we have – as you mentioned before – the $100 worth of extra inventory
and $100 extra debt on the Balance Sheet and now we’re going to go and sell the iPods for $200
and we’ll have a Cost of Goods Sold of $100 here.

Interviewee: Ok, got it. So on the Income Statement, starting from Revenue, Revenue would
immediately go up by $200 because you’ve sold the iPod for $200, but the Cost of Goods Sold
would also rise by $100, so therefore your Gross Profit would go up by $100, because Gross
Profit is obviously just Revenue less the Cost of Goods Sold. And your Operating Income in
this instance would go up by the same amount. Everything else would stay the same, and
Pretax Income would be up by $100 as well – and assuming the 40% tax rate, like you said, Net
Income would rise by $60.

So on the Cash Flow Statement, Net Income would be up by $60 now because of the previous
discussion, and Inventory has gone down by $100 since we’ve sold it. Since that Asset is

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decreasing, that adds $100 to the Cash Flow from Operations. There would be no other
changes, and overall we’d be up by $160 in Net Change in Cash.

And on the Balance Sheet, the Cash Balance is up by $160 now, and Inventory is down by $100,
so the Assets side is up by $60 overall. The other side would also be up by $60 because of the
rise in Net Income – and by “the other side” I mean the Shareholders’ Equity side – so that’s
where everything balances out.

Interviewer: Ok, great. And I see you know your accounting there – most people I speak with
don’t actually get that question right on the first try. So that’s great – I think based on that, we
can move onto some more advanced topics here, more related to valuation and modeling now.

Since you worked for an entire summer at possibly one of the top investment banking groups in
the US, I’ll assume that you know the basics of valuation and basic valuation methodologies. So
I want to look at a little bit of a more unusual scenario – and I want to go back in time and go
back to a time when Facebook was new. Since it’s a new company at the time, it has a lot of
users but it has no revenue, no EBITDA, and no profit – so we can’t exactly use the standard
valuation methodologies here.

So I guess my question is, how would you a value a company, like Facebook in its early days,
that didn’t even have any revenue yet?

Interviewee: Well, I didn’t really work with any companies in that early of a stage, but what I
think you would do is probably just project out the company’s Cash Flows really far into the
future and perhaps maybe use a DCF or something of that sort.

Interviewer: Yeah, I think sometimes you can do that but I think with a high-growth Internet
company or high-growth biotech company, it can be really hard to predict the Cash Flows. So
in this case, let’s just assume that we can’t actually predict the Cash Flows – do you think there’s
anything else of value that the company has that we could use in the valuation?

Interviewee: Well, if there’s no revenue or profit, then…

Interviewer: Yeah, I definitely agree with you – it’s not going to be a conventional valuation
here. But at the same time, as I said, it is in its early days but it does have users, traffic – so what
about those?

Interviewee: Yeah, that makes sense to me. I guess some of the more important performance
indicators would be registered users, or number of monthly visitors, or something of that
nature.

Interviewer: Ok, that’s definitely true – and even for an early stage company like that, even if
they don’t have revenue or profit you can definitely use those kinds of metrics to value it. In

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this specific case – let’s just take, for example, the monthly visitors metric that you mentioned –
so how would you actually use that in a valuation if you’re looking at Facebook?

Interviewee: Right, so we could use those metrics as a proxy for financial metrics and say
Facebook was, at whatever the valuation was, $15 billion, was an x multiple on 150 million
monthly unique visitors. And whatever that multiple is, obviously we could use that and apply
that to the company we’re trying to value here – although we also should keep in mind that
Facebook was probably a premium given that it’s the market leader and pretty much the
premier name in social networking.

Interviewer: Right, you quoted some of the more exact figures there. But I think you have the
basic idea right – that we’re going to use Comparable Companies or Precedent Transactions
here, because that’s all we really can use with such an early-stage company. And then look at
metrics like the unique visitors or registered users, and use those for valuation multiples rather
than the usual revenue or EBITDA multiples, then apply them to Facebook to get its valuation.

That’s a little bit of a tricky question, so let’s just move onto a related topic here. So I want to
talk about multiples briefly – so first off, when you were doing your banking internship at
Morgan Stanley this past summer, what kinds of multiples did you use in valuations there?

Interviewee: We used a wide variety of multiples, but some of the key ones were the Enterprise
Value / Revenue, Enterprise Value / EBITDA, Price / Earnings, and sometimes depending on the
industry we might also look at Price / Book or Enterprise Value / EBITDAR.

Interviewer: Ok, good. And you mentioned EV / EBITDA – why would you use Enterprise
Value / EBITDA as opposed to, say, Market Cap / EBITDA or Equity Value / EBITDA?

Interviewee: Enterprise Value reflects all the investors in the company – whether they’re the
equity holders, the debt holders, or the preferred stock holders or anything else, and EBITDA
reflects the profit available to everyone – all the investors. So if you used Market Cap, basically
that would only be representing the equity holders, and so it wouldn’t really be apples-to-
apples.

Interviewer: Ok, good. And I see you definitely know your valuation and your multiples – so
let’s move onto a couple other topics.

So one thing you mentioned before is that you worked on a couple different M&A deals while
at Morgan Stanley – so maybe we can go into a bit more detail on the merger model, or
accretion/dilution model – whatever you want to call it – and how acquisitions of companies
actually work.

Interviewee: Yeah, absolutely.

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Interviewer: So let’s say that we have a company making a $500 million acquisition of a smaller
company. And I’m going to assume that you know the basics of how to set up the merger
model and all the basics of setting that up, going through the assumptions, and projections and
all.

But what I’m interested in – what I want to talk about – is how they should actually pay for the
smaller company. As you know, there are basically 3 ways you can buy a company – you can
use cash, you can issue stock, or you can raise debt when you’re doing a merger model.

And let’s say that the buyer has unlimited resources, and they have no constraints on how they
can pay for it – they can use cash, stock or debt, or they can use any combination thereof.

So which one do you think they would choose to make this $500 million acquisition if, again,
they had unlimited resources?

Interviewee: Ok – now which company has the higher P/E ratio, the buyer or the seller?

Interviewer: That can sometimes be relevant to such a model, but actually in this case it’s not
really relevant – so I think you might actually be making it trickier than it is. Maybe one way to
think about this is to think about the acquisition effects of using cash vs. using stock vs. debt –
so maybe think about the relative interest rates, or how much each one is actually going to cost
here.

Interviewee: Ok, so if they use Cash then there’s Foregone Interest on that Cash – and in this
market, this environment, it’s probably roughly 4-5% of the $500 million they would use. And
if they use Debt, then they would probably pay higher than that – roughly, let’s just say, 8-10%
of Interest Expense on that Debt.

Interviewer: Right, that’s exactly right, that Debt is almost always going to incur a higher cost –
higher interest rate – than the Foregone Interest on Cash. So effectively the Cash would “cost”
less than Debt. So we went through that – how does Stock stack up and compare to those 2
options?

Interviewee: Well, it’s tough to say what the “Cost of Stock” is… could probably go either way.

Interviewer: Ok, well, what about thinking about it like this: let’s say you’re doing a Discounted
Cash Flow model and you’re calculating the Weighted Average Cost of Capital. And you’re
looking at the Cost of Equity specifically, and just thinking about how you do a model – is the
Cost of Equity ever less than the 4-5% interest for Cash that you just mentioned?

Interviewee: No, you’re right, that’s a good point. Most of the time it’s probably over 10%.

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Interviewer: Right, so we’ve seen the different effects of each of the methods now. So going
back to the original question, how do you think you’d pay for this company if you could afford
whatever you wanted to do?

Interviewee: Based on the cost numbers that we just talked about, Cash seems to be the
cheapest form of financing in this case.

Interviewer: Yeah, exactly. So all else being equal, usually a company with excess cash will
prefer to use that in an acquisition since it costs less than the other alternatives and because it’s
easier and less risky to get a deal done with cash compared to debt – since debt issuances could
always fall through if the market turns bad – or stock, which again, could fall through if the
market turns bad.

Related to that last question we went through, we’ve seen that – we’ve just went over why a
company buying another company would usually try to pay in cash – but if that’s the case, then
why is that a private equity firm in a Leveraged Buyout would try to use debt to finance the
acquisition?

Interviewee: Well, in an LBO, the private equity firm is really trying to earn a high return on its
investment by using the minimum amount of cash possible – so it’s a lot different from a
strategic company buying another company for strategic reasons, where they care more about
reducing the cost of the acquisition vs. earning just a high return.

Interviewer: Right, so it’s a different scenario – they’re going to sell the company at some point,
so they want to reduce the value of the equity stake they’re putting into it so that they can get a
higher return on that when they sell it. Is there any other reason why it might be a little bit less
risky to use Debt in an LBO vs. using Debt in a standard acquisition? For this one, you might
want to think about who “owns” the debt in either case.

Interviewee: Right, ok. So in a normal acquisition, the Combined Company would hold the
Debt, so they’d have to pay it back as well. But in an LBO, the company being acquired owns
the Debt, and they are the ones that have to pay it back – not the private equity firm.

Interviewer: Right, so as you said, in an LBO it’s the company that assumes the risk of the Debt
and then pays for everything – the PE firm effectively uses Debt and gives it to the company to
pay back to boost their own returns, since it’s a lot easier to earn a good return on $50 million of
equity vs., say, $100 million of equity.

So another topic I wanted to go over here is: so in a merger model a common rule of thumb is
that if it’s an all-stock deal, and the buyer has a higher P/E ratio than the seller, it will usually be
accretive, just because of the basic math and because it’s an all-stock deal that’s just generally
how it works because they’re effectively acquiring the earnings for less than what their own
earnings multiple is.

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Can you think of any cases where this rule might NOT hold up?

Interviewee: Let’s see… I’m not really sure… but sometimes if there’s Cash or Debt involved
then that rule probably doesn’t apply, but I think in the cases where it’s all-stock, it holds true.

Interviewer: Right, so I agree with you that it’s true in most cases – maybe let’s just walk
through an example.

Let’s say the buyer has a P/E of 12x and the seller has a P/E of 11x, and the deal turned out to be
dilutive. What would that tell us – could it be that maybe our calculations for P/E or EPS might
be off or calculated differently?

Interviewee: Yeah, maybe the EPS is calculated differently?

Interviewer: Yeah, and that’s what you see happening sometimes and that’s why you have to
be careful when, you’re just looking at companies briefly – because sometimes they’ll include
Stock-Based Compensation for example, sometimes they won’t, sometimes they’ll include one-
time charges or Amortization of Intangibles in the EPS, and sometimes they won’t. So you just
have to be really careful that you’re showing exactly the same things, because sometimes it’s
calculated differently and you just have to be careful of that one.

So in the remaining time, let’s just go through a couple other topics I wanted to cover briefly.
So let’s turn our attention to the Discounted Cash Flow – and again, I’m going to assume that
you know how to construct a basic DCF.

But what I want to go into is a little bit more on the Free Cash Flow calculation. So normally
when we’re calculating Free Cash Flow we exclude the Interest Expense – so we’re using the
Unlevered Free Cash Flow.

And normally when you see the Free Cash Flow line on a Cash Flow Statement, it goes down
from Net Income, so the Interest Expense is included. Why is it that in a DCF – why is it that
you think we’d be using the Unlevered Free Cash Flow instead?

Interviewee: I’m not 100% certain, but I think it has to do with the company’s capital structure
once again. So if you were to include Interest Expense, that would be more similar to Net
Income – and you always use Market Cap with Net Income since it’s only available to the equity
shareholders.

Interviewer: Right, exactly, and so I guess another way to look at this – when you’re doing a
DCF, what are you really calculating in terms of the value of the company when you add the
Net Present Value of the Cash Flows to the Net Present Value of the Terminal Value?

Interviewee: I believe that would be the Enterprise Value of the company, so to make a valid
comparison you’d want to exclude Interest Expense.
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Interviewer: Right, exactly, so essentially we’re doing it because we’re interested in the
Enterprise Value of the company – not the Equity Value, at least in most cases.

So let’s flip this around and say that this time we are actually interested in the Equity Value of
the company, and so as a result we’re going to be using the Levered Free Cash Flow and
keeping in the Interest Expense.

Now, normally in a DCF when we’re discounting the Cash Flows and discounting the Terminal
Value of the company, we’re using WACC – but if we’re trying to get to Equity Value rather
than Enterprise Value, what would we be using as the discount rate?

Interviewee: Well, for WACC you would include the Cost of Debt, the Cost of Equity, and the
Cost of Preferred Stock in the calculation – so if you wanted to find the Equity Value, you
would probably just use the Cost of Equity for the discount rate.

Interviewer: Right, exactly. And it’s definitely less common than the Unlevered Free Cash Flow
and the WACC method, but sometimes you do see it.

Speaking of the Discount Rate, one part of the calculation for that is this whole notion of Beta –
so can you just explain why you need Beta when you’re calculating the Weighted Average Cost
of Capital and where you get it from?

Interviewee: Yeah – so the Beta part shows up when calculating the Cost of Equity in the
WACC calculation, and it’s necessary to adjust for how “risky” a company is. And the way I
was taught to get is, I would usually just look up each of the Comparable Companies’ Betas on
a Bloomberg, and then un-lever them to get the median or average, and then apply that to the
company and re-lever it, taking into account any debt that the company has. Then you use that
to calculate the Cost of Equity.

Is that detailed enough?

Interviewer: No, that’s good. I think that’s actually the easiest question you’ve gotten from me
so far!

<Laughs>

And I see we’re running short on time – we just have a few minutes left, so I just wanted to go
over a few more questions briefly on LBOs and LBO models – and I see from your resume that
you worked on that a little bit at Morgan Stanley.

So maybe you can just start by walking me briefly through an LBO Model – I don’t want tons of
detail here, because I know it can get very complicated – I just want a very high-level view of
how it works.
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Interviewee: Ok. So first you probably start off by making assumptions about the Purchase
Price, and how much Debt and Equity is used – and then you also have to make assumptions on
things like the Interest Rate on the Debt.

For the second step, you’d probably create a Sources & Uses table basically showing how you’re
financing the deal and how much capital you’re using to buy the company’s Equity, pay off any
existing Debt and on top of that, pay the transaction fees associated with the LBO. And next,
you need to adjust the company’s Balance Sheet for the new Debt and Equity values and
anything else created in the deal, such as Goodwill & Intangibles.

After that, you probably would project out their Income Statement, Balance Sheet and Cash
Flow Statement, and then I would create a Debt Schedule showing how much Debt is paid off
each year.

Finally, you make some assumptions on the exit after 3-5 years typically and then look at the
range of values for the EBITDA exit multiple, and use those to calculate the returns in each case.

Interviewer: Ok great, that’s exactly what I was looking for – just a general overview like that.
Now I just want to go through a scenario here – so let’s say that we have an LBO model and we
want to get to at least a 20% return. And so right now, the returns you’re getting are just too
low – so they’re in, say, the 10-15% range rather than the 20% range.

So which variables or which assumptions in the model would you adjust in order to boost the
return?

Interviewee: Well, I think a lot of factors affect the return – the company’s growth, the
profitability, the purchase and the exit multiples, the debt… interest rates… and those are just
some of the things. But there are a lot of variables I think.

Interviewer: Right, I agree there’s a lot that affects it. Out of the ones you mentioned, what do
you think really impacts the return by the most?

Interviewee: I’d say probably the Purchase Multiple and Exit Multiple – just because it’s easier
to get a good return if you’re either buying it at a really cheap price or exiting at some high,
premium valuation.

Interviewer: Ok, yeah, that’s definitely true – those two do tend to impact the LBO model the
most. And of course leverage also matters, but usually has a bit less of an impact.

So I see that we’re actually just about out of time – have about a minute left here – but before we
wrap up I just wanted to give you a chance – did you have any questions you wanted to ask
me?

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Interviewee: Yeah, definitely. I was wondering if you could just tell me a little about your
background and how you got started in investment banking?

Interviewer: Sure, so I actually started out at a much smaller firm – a local boutique – as an
Analyst, right out of undergraduate. Back then, we were just getting out of a recession, the
economy was really bad, and it was pretty hard to work at some of the bigger places.

So I thought I was going to pursue venture capital one day since I was always interested in
technology investing – but I found that I really didn’t like a lot of the job at the junior levels.
The lifestyle was better in some ways than banking, but I actually found that I liked the pace
and I liked actually getting to work closely with clients instead of just looking at companies and
not really doing that much in the way of deals.

I ended up here in our M&A group, and it’s been a really, really good experience so far – a lot of
our Analysts have gone onto great private equity firms, hedge funds, recently we’ve had some
that have gone to – this past year – who have gone to KKR, TPG, Cerberus. So if you’re
interested in that, there’s definitely lots of opportunities.

Well I see we’re over time again here – so sorry for keeping you from your next interview, but it
was great meeting you, I really enjoyed our discussion, and I see you really have a very strong
command of finance.

So good luck with the rest of your interviews, and feel free to contact me if you have any
questions.

Interviewee: Absolutely, will do – thanks so much for taking the time.

Interviewer: Ok, take care.

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