30 Common IB Technical Questions

Question 1

What are the three main financial statements?

Answer 1

The Income Statement discloses a company’s revenues and expenses, which together yield net income over a period of time. The Balance Sheet discloses a company’s assets, liabilities, and equity on a specific date. The Cash Flow Statement starts with net income from the Income Statement; then adjusts for non-cash expenses, non-operating expenses like capital expenditures, changes in working capital, or debt repayment and issuance, to arrive at the company’s closing cash balance

Question 2

How are the three main financial statements connected?

Answer 2

Net income flows from Income Statement into the Cash Flow Statement (CFS) as Cash Flow from Operations. Net income less dividends are added to retained earnings from the prior period’s Balance Sheet (BS) to come up with retained earnings as on the date of the current period’s BS. The opening cash balance on the CFS is from the prior period’s Balance Sheet while the closing cash balance on the CFS is the balance on the current period’s Balance Sheet.”

Question 3

If you could use only one financial statement to evaluate the financial state of a company, which would you choose?

Answer 3

The cash flow statement because it shows the actual liquidity of the company and how it is generating and using cash. The balance sheet just shows a snapshot of the company at a point in time, without showing the performance of the company, and the Income statement has several non-cash expenses that may not be affecting the company’s health and can be manipulated. Overall, the key to a great company is generating significant cash flow and having a healthy cash balance, both of which are disclosed in the CF statement.

Question 4

How would a $10 increase in depreciation expense affect the three financial statements (assuming a 40% tax rate)?

Answer 4

In the income statement, the depreciation increase of $10 is set off by a reduction of $4 on taxes as depreciation is a tax-deductible expense for the net reduction in net income of $6. In the cash flow statement, net income is reduced by $6, depreciation is increased by $10, net cash from operations and total cash is increased by $4. This increase in cash is because depreciation is a non-cash expense that has no impact on cash while the reduction in taxes affects the cash flow. In the balance sheet, property, plant, and equipment balances reduce by $10, cash balance increases by $4, and retained earnings reduce by $6 due to the reduction in net income.

On the income statement
- $10 depreciation expense, 40% tax rate
- Reduction in net income of $10 x (1 - 40%) = $6

Reduction in net income flows to cash from operations
- Net income reduced by $6
- Depreciation increases by $10
- Net increase in cash from operations of $4
- Ending cash increases by $4

Ending cash flows onto the balance sheet
- Cash increases by $4
- Property, plant, and equipment lose $10 in value
- Net decrease in assets of $6, matches the net drop in shareholder equity due to the reduction of retained earnings from the $6 is net income

Question 5

Walk me through the Income Statement

Answer 5

The first line of the Income Statement represents revenues or sales. From that, we subtract the cost of goods sold, which gives gross margin. Subtracting operating expenses from gross margin gives us operating income (EBIT). We then (add/subtract) interest expense (income), taxes, and other expenses (income) to arrive at Net Income.

Question 6

What is Enterprise Value?

Answer 6

Enterprise Value (EV) is the value of an entire firm, both debt, and equity. This is the price that would be paid for the company in the event of acquisition without a premium.

EV = Market Value of Equity + Debt + Preferred Stock + minority interest - Cash

Question 7

What is WACC and how do you calculate it?

Answer 7

WACC is the acronym for Weighted Average Cost of Capital. It reflects the overall cost for a company to raise new capital, which is also a representation of the riskiness of investment in the company (higher the risk, higher the cost of capital). It is commonly used as the discount rate in a discounted cash flow analysis to calculate the present value of a company’s cash flows and terminal value.

WACC = [(MVequity/BVdebt + MVequity + Pstock)(COE)] + [(BVdebt/BVdebt + MVequity + Pstock)(1-t)(COD)] + [(Pstock/BVdebt + MVequity + Pstock)(COPstock)]

Question 8

What is EBITDA?

Answer 8

EBITDA stands for Earnings before Interest, Taxes, Depreciation, and Amortization.

It gives us a good idea of a company’s profitability and is a quick metric for free cash flow because it will allow you to determine how much cash is available from operations to pay interest, CAPEX, etc.

EBITDA = Revenue - Expense (except depreciation and amortization)

It is also often used for rough valuations in a comparable company or precedent transaction analysis as part of the EV/EBITDA multiple.

Question 9

Would you be calculating enterprise value or equity value when using a multiple based on free cash flow or EBITDA?

Answer 9

EBITDA and free cash flow represent cash flows that are available to repay holders of a company’s debt and equity, so a multiple based on one of those two metrics would describe the value of the whole business from the perspective of all its investors.

A multiple such as the P/E ratio, based on earnings alone, represents the amount available to common shareholders after all expenses are paid, using which you would be calculating the value of the firm’s equity

Question 10

Can a company have a negative book equity value?

Answer 10

Book equity value is the accounting value of equity derived by subtracting the value of a company’s liabilities from its total assets. It is the total shareholder’s equity, an amount shown as “Total Equity” in the Balance Sheet of the company.

Yes. If there are large cash dividends or if the company has been operating at a loss for a long time.

Question 11

What is typical of an LBO (leveraged buyout) transaction?

Answer 11

A firm (usually a PE firm) uses a high amount of debt (70 - 90%) to finance the purchase of a company, then uses the company’s cash flows to pay off that debt over time.

The acquired company’s assets may be used as collateral. Ideally, the original debt of the acquired company would have been partially retired at the time of exit.

In the context of a private equity investment, the debt acts as a way to magnify returns (boost IRR for the fund), but it can also backfire if the acquisition turns south.

Question 12

Why would a company issue equity rather than debt to fund its operations?

Answer 12

• If the company feels its stock price is inflated, it can raise a relatively large amount of capital with comparatively minimal dilution to existing shareholders.
• If the projects the company is looking to invest in do not produce immediate or consistent cash flows to pay its debt.
• If the company wants to adjust the cap structure or pay down debt.
• If the owners of the company want to sell off a portion of their ownership.

Question 13

How is it possible for a company to have a positive net income but go bankrupt?

Answer 13

This is possible if working capital erodes (such as increasing accounts receivable, lowering accounts payable, lower inventory turnover) or the company is growing so fast that it’s unable to raise enough capital to fund operations. Another possibility is the existence of financial fraud.

Question 14

What are some ways you can value a company?

Answer 14

Comparable companies or multiples analysis: This is the most common way to value a company. This method attempts to find a group of companies that are comparable to the target company and to work out a valuation based on what they are worth. The idea is to look for companies in the same sector and with similar financial statistics (Price to Earnings, Book Value, Free Cash Flow, EBITDA, etc) and then assume that the companies should be priced relatively similarly.

Discounted cash flow analysis: This method involves calculating the sum of the present values of all future cash flows to give the value of the entire company including debt and equity, which is also called enterprise value.

Precedent Transactions Analysis:
the price paid for similar companies in the past is considered an indicator of a company’s value. Precedent transaction analysis creates an estimate of what a share of stock would be worth in the case of an acquisition.

Market capitalization

Question 15

Which of the valuation methodologies will result in the highest valuation?

Answer 15

from highest valuation to lowest valuation:

• Precedent Transaction - Since a company will pay a control premium and a premium for synergies coming from the merger, values tend to be high.
• Discounted Cash Flow - Those building the DCF model are frequently optimistic in their projections.
• Comps - Based on other similar companies and how they are trading in the market. No control premium or synergies.
• Market Valuation - Based on how the target is being valued by the market. Just equity value, no premiums or synergies.

Question 16

Why might there be multiple valuations of a single company?

Answer 16

Each method of valuation will generate a different value because it is based on different assumptions, different multiples, or different comparable companies and/or transactions. Generally, the precedent transaction methodology and discounted cash flow method lead to higher valuations than comparable companies’ analysis or market valuation does.

The precedent transaction result may be higher because the approach usually will include a “control premium” above the company’s market value to entice shareholders to sell and will account for the “synergies” that are expected from the merger.

Question 17

Walk me through a DCF.

Answer 17

Project out cash flows for 5 - 10 years depending on the stability of the company

Discount these cash flows to account for the time value of money

Determine the terminal value of the company - assuming that the company does not stop operating after the projection window

Discount the terminal value to account for the time value of money

Sum the discounted values to find an enterprise value

Subtract the present value of debt (this is generally the market value of debt) and then divide by diluted shares outstanding to find an intrinsic share price

Question 18

Follow up questions to “walk me through a DCF” question:

• Why do you multiply by (1-tax rate)?
• What is the cost of equity?
• What is the exit multiple method for determining the terminal value?

Answer 18

1. You do this because interest expense (the cost of debt) is tax-deductible so you need to account for the benefit provided by this “debt tax shield.”
2. The cost of equity is usually calculated using the Capital Asset Pricing Model (CAPM).
   CAPM = Risk-free rate + Beta * (Expected market return - Risk-free rate)
3. Find an industry average multiple and multiply it by final year revenue (if using EV/Revenue) or final year EBITDA (if using EV/EBITDA).

Question 19

What is an Initial Public Offering (IPO)?

Answer 19

An IPO is the first public sale of stock in a previously private company. This is known as “going public.” The IPO process is incredibly complex, and investment banks charge high fees to lead companies through it. Companies go public for several reasons-raising capital, cashing out for the original owners, and investor and employee compensation.
Some negatives against “going public” include sharing future profits with public investors, loss of confidentiality, loss of control, IPO fees to investment banks, and legal liabilities.

Question 20

What is the difference between accounts receivable and deferred revenue?

Answer 20

Accounts receivable is revenue, which has been earned and recognized because the product has been delivered, but the customer has not yet paid the cash. Deferred revenue is cash that has been collected for products that have not yet been delivered, so the revenue has not yet been recognized. Accounts receivable is an asset on the Balance Sheet, whereas deferred revenue is a liability.

Question 21

When calculating enterprise value, do you use the book value or the market value of equity?

Answer 21

You should use the market value of equity always because the book value is not adjusted once it is recorded in the books at the time of issue of the shares. It is common to very often see a share priced in the hundreds or thousands having a face value of $1 or $10. This is due to the historical nature of accounting. Hence, the book value of equity is useless for any kind of valuation, and market value is the preferred metric to use.

Question 22

If enterprise value (EV) is $80mm, and equity value is $40mm, what is the net debt?

Answer 22

If we assume there is no minority interest or preferred stock, then Net Debt will be $80mm – $40mm, or $40mm.

Question 23

What is the difference between cash-based accounting and accrual-based accounting?

Answer 23

Cash-based accounting recognizes sales and expenses when cash flows in and out of the company.

Accrual-based accounting recognizes revenues and expenses as they are incurred regardless of whether cash flows in or out of the company at that exact time.

Accrual-based accounting is the more common method for large corporations.

Question 24

What are the major factors that drive mergers and acquisitions?

Answer 24

• Achieving synergies (cost savings)
• diversifying or sharpening the focus, market, or products of the company
• gaining access to new technologies
• eliminating a competitor from the market or growing market share
• increasing supply-chain pricing power by buying a supplier or distributor
• improving financial metrics and numbers

Question 25

All else equal, should the WACC be higher for a company with a $100 million market cap, or a company with a $100 billion market cap?

Answer 25

• Normally, the larger company will be considered “safer” and therefore will have a lower WACC all else being equal. However, depending upon their respective capital structures, the larger company could also have a higher WACC.
• Without knowing more information about the companies, it is impossible to say. If the capital structures are the same, then the larger company should be less risky and therefore have a lower WACC. However, if the larger company has a lot of high-interest debt, it could have a higher WACC.

Question 26

What is Beta?

Answer 26

Beta is a measure of the volatility of an investment compared with the market as a whole. The market has a beta of 1, and hence, investments that are more volatile than the market have a beta greater than 1 while those that are less volatile have a beta less than 1.

Question 27

How/why do you lever or unlever Beta?

Answer 27

Unlevering beta allows us to remove the effect of debt in the capital structure. This shows us the beta of the firm’s equity had it not used any leverage in its capital structure. Also, if we are trying to do a market comparison with a company that’s not on the market (so no beta), you can take a comparable company and unlever its beta and use this unlevered beta as a proxy for the unlisted company’s beta.

Question 28

What is net working capital?

Answer 28

Net Working Capital = Current Assets – Current Liabilities

Current assets include items on the Balance Sheet like inventory, accounts receivable, prepaid expenses, and other short-term assets. Current liabilities include items such as accounts payable, accrued expenses, deferred revenue, and other short-term liabilities.

An increase in net working capital means more cash is tied up in the operations. This could be from increasing current assets like inventory or accounts receivable. If you increase inventory, for example, it is not (yet) a cost on the Income Statement, but still blocks the cash that was used for purchasing the inventory which needs to be accounted for on the CF statement. This is why in calculating free cash flow you subtract an increase in net working capital.

A decrease in net working capital means less cash is tied up in operations. This could happen due to changes such as increasing accounts payable or reducing inventory. If you reduce inventory, it means you are selling more goods than you are producing, which means you are realizing a cost on your Income Statement. If you are increasing accounts payable, you are preserving your liquidity by taking a little bit longer to pay your vendors for your raw materials/inputs.

Sample Answer:
Net Working Capital is calculated as current assets minus current liabilities. It is a measure of a company’s ability to pay off its short-term liabilities with its short-term assets. A positive number means they can cover their short-term liabilities with their short-term assets. A negative number indicates that the company may have trouble paying off its creditors, which could result in bankruptcy if cash reserves are insufficient and further financing cannot be arranged.

Question 29

What happens to free cash flow if net working capital increases?

Answer 29

Intuitively, you can think of working capital as the net dollars tied up to run the business. As more cash is tied up (either in accounts receivable, inventory, etc.), free cash flow will be reduced.

Remember that if the assets go up in value (denoting a purchase of assets), this is a use of cash; and if a liability goes up (denoting funds received), it is a source of cash.

Sample Answer:
You subtract the change in Net Working Capital when you calculate Free Cash Flow, so if Net Working Capital increases, your Free Cash Flow decreases and vice versa.

Question 30

How can a company raise its stock price?

Answer 30

• A company can repurchase stock, which lowers the number of shares outstanding and therefore increases its value per share.
• It can improve operations to produce higher earnings, causing its EPS to be higher than anticipated by industry analysts, which will send a positive signal to the market.
• It can announce a change to its organizational structure such as cost-cutting or consolidation, which would lead to increased earnings in general.
• It could announce the institution of a dividend policy or an increase in an existing dividend.
• It can announce an accretive merger or an acquisition that will increase earnings per share.

Question 31

If you were the Chief Financial Officer (CFO) of a Fortune 500 company, what would be your concerns? Explain from a high level what the long-term financial implications are for your company.

Answer 31

Fortune 500 companies are usually in the mature stage of their business lifecycle. This means they have stable growth accompanied by a good amount of stable cash flows and balances. As a CFO of one, I would look out for signs of declining products or services to be discontinued while also actively keeping an eye out for opportunities to expand and grow, either through mergers and acquisitions or by increasing the spending on internal research and development.

• IS: product-wise revenue growth, cost, and margins, profits R&D expenses
• BS: liquidity ratios, capital assets, credit ratings
• CFS: CFs in the short and long term, raising money for new acquisitions