Interview Questions

Question 1

Why investment banking?

Answer 1

The answer to this question is very personal; it could vary from the focus on the client, the intellectual challenge, the teamwork, the colleagues and/or the project management skills. Many fail to understand what M&A really is: advising clients on decisions that will likely transform how they do business in their industry. Think of the example of the third and the fourth largest players in an industry merging and becoming the largest one. M&A is a strategic competitive response. Competitive pressures, changing markets, and other forces may put pressure on management to seek external means to improve shareholder value. Mergers, acquisitions and restructuring are an integral part of every company’s strategic development plan.

Question 2

Walk me through your resume / tell me about yourself / tell me who you are:

Answer 2

Almost every interview starts with this question. This is a way for bankers to form a preliminary opinion
about you and to see how well you can sell your story.
The answer should not take more than 2 minutes and you should focus on strengths and skills that are
relevant to investment banking. You do not have to cover everything on your resume, but you should
highlight all the main points by giving a short preview of the stories you want to tell them later. Focus on
relevant achievements and transferable skills.
By the time you go for your interview, you should have repeated your story so many times that even you
should be bored of it. Be careful not to sound mechanical.

Question 3

Why did you major in … ?

Answer 3

If it was business related you can discuss your interest in the area. For different majors you can emphasize
how you liked the challenge and/or you had a personal interest in the field. But also mention you took your
programme to study business.

Question 4

Why your university?

Answer 4

Find your story building on the school strengths.

Question 5

Why not a different course or programme?

Answer 5

Emphasize the strengths of your chosen course and point out some of the key coursework which you
believe makes you an ideal candidate for the role – i.e. not just the Finance courses but the strategy
courses as well.

Question 6

What do you do for fun?

Answer 6

If you have anything unique or uncommon (climbing, wine tasting, mountaineering, investing) you should
bring that up. It will be a differentiating point. You should also highlight what is fun for you and quote some
of the transferable skills that may apply to banking (multitasking, teamwork, leadership).

Question 7

Tell me something interesting about you that is not listed on your resume

Answer 7

Use common sense. Talking about a trip in Italy or the Manchester – Liverpool match you saw last month is
totally fine.

Question 8

What are your favourite movies /books?

Answer 8

Pick something that you really liked, but avoid being overly finance focused with titles such as Liar’s Poker
or Wall Street. Avoid saying you really like Harry Potter. Pick a balanced choice (you want to be seen as a
normal person!)

Question 9

What you don’t like about banking?

Answer 9

There is no correct answer to this question. Usually no one likes working all the weekends for multiple
months (unless you live only for your work and this would make you quite boring). Conclude saying that
you understand that M&A situations are so critical for clients and often have tight deadlines; therefore
investment bankers have to work so hard. It’s part of price you should be prepared to pay for doing such a
challenging and exciting job.

Question 10

I see you changed quite a few jobs before business school. If we hire and invest you, are you going
to leave early?

Answer 10

Your answer should show that you are a good team player and an ambitious young professional striving to
grow. While it may be strange if you changed 4 jobs because you did not like the people, it is rational if you
did so in order to grow professionally.
You should also explain why you think that banking is a long-term choice (it has all the characteristics you
were looking for when you were changing positions)

Question 11

You have an engineering background. Why change your tech job with Banking?

Answer 11

Keep it as personal as possible. Frame your precedent job in a positive light, but say that you like the
business side of technology more than the tech side by itself. You want to advise tech companies in
extraordinary operations that will change the competition in the industry.
Many students also point out that they felt capped in their growth since limited advancement opportunities
are typical in the corporate world.

Question 12

You have been an auditor. Why you now want to switch to Banking?

Answer 12

As usual, keep it personal. Your story is your differentiating factor.
Many students find the faster pace of IBD and the career advancement opportunities more attractive. Say
that you are excited about the opportunity to certify not just a small part of a balance sheet, but to help the
CEO of a multinational corporation change the shape of a company and the competition dynamics. It is
always helpful while making such statements that you also back up these statements with either personal
examples or examples from a recent transaction.

Question 13

You have been a successful M&A lawyer with a potential for being a partner in few years. Why
would you forego a lucrative career and enter in banking as a summer associate?

Answer 13

While being an M&A lawyer has many important transferable skills, many students with a law background
find their job too narrow and focused on only one part of the deal.
Point out how you would like to lead the client on business/investment side, which is of course the most
important.

Question 14

You have worked in a consulting firm for three years, why change for banking?

Answer 14

Make your own story, starting from a good understanding of what M&A advisory is.Many students say that in consulting they learned how to approach management and analyse market and
companies, but that the work was too project specific and that often you never got to see what appended
after it.
M&A advisory it is always a high-level view of the company and it is deeply dependent with the final results
of the recommendation (bid price – deal closing).

Question 15

In which other sectors are you interviewing? Only in banking?

Answer 15

Only banking. You should already be committed to banking when at the interview, or someone else will.
IBD is a very demanding job, with 80-100 hours per week. It requires passion and commitment.

Question 16

Recently some Analysts and Associates have left for Private Equity. If the opportunity comes out,
would you leave our team?

Answer 16

Recruiters want to hire students with a long-term view on the job. You should say that Private Equity is a
possibility that every banker has to consider in their career, but that you do not see a foreseeable career
path in PE due to the lack of structure and internal promotion potential. Moreover, decreasing fund size and
increasing competition are seriously threatening the traditional PE model. Back up statements with recent
numbers.

Question 17

You had been working in a small boutique, and you liked working in a small team. Why do you want
to move to a larger bank?

Answer 17

Always refer to your previous experience in a positive way. Say you loved it and you learned a lot, but that
you felt you touched a ceiling in your growth (only middle market deals, only one country deals, the centre
of the IB profession is London) and therefore moving to a large investment bank is your natural next step.

Question 18

Which other banks you are interviewing with?

Answer 18

It’s ok to say you are interviewing with all the other large banks. You want to work in investment banking
and you want to maximize your probabilities to get a job. It’s perfectly rational and everyone should agree
with you. It’s advisable to conclude by stating your interest in the interviewer’s bank of course.

Question 19

When did you start being interested about finance? You say that you are very passionate and
interested in investment banking. Why did it take you so long to make this switch?

Answer 19

It should flow with your story. Make sure it’s reasonable and credible, and not too recent. Possibly you
should have done your programme as a way to move into a career in finance.

Question 20

Why our bank?

Answer 20

What are our strengths and why you would be a good fit in our team? Think about the banks specific
characteristics and strengths and try to say why you feel you really appreciate/fit with their culture. Also, try
to study the most recent annual report and the most current statements by the senior management of the
bank. Ensure that you are aware of some of the major happenings relating to the bank.

Question 21

I am concerned about (a certain area)… Can you explain more in detail?

Answer 21

Everyone will be questioned on this line. If you worked in IBD they will ask why you left; if you are a career
changer they have many angles to explore
Ask your study group to question you on your reasons behind the career move, find out in advance what
the main areas of concerns will be for recruiters and be ready (and proactive) to address them at the
interview.
Sometimes the interview can become quite stressful with your interviewers questioning everything you say
in order to test the sincerity of your statements. Relax. it is just part of the process. If you have a well
thought out story and you rehearsed your answers through many mock interviews you will be fine.

Question 22

Where will you be in 10 years? What’s your career goal?

Answer 22

A business school graduate should be committed to a career in banking, or at least be able to convince the
interviewer that he or she is. For a career changer, some degree of doubt is acceptable.
However, you should state that you have networked and studied the industry thoroughly and you are ready
to work long hours in a team on more than one deal, and you look forward to your summer internship so
you can have the opportunity to put in practice everything you have learned.

Question 23

Is there anything else you would like to tell me?

Answer 23

Consider yourself fortunate if you get this question. This is an opportunity to sell yourself in total freedom,
go with why banking, why this bank and why you.

Question 24

If we were to make you an offer right now, would you accept it? Assuming you get an offer, how will
you make your decision between us and other firms?

Answer 24

Some banks are particularly sensitive about their acceptance rate; therefore they may ask the question to
candidates at the final round.
It is important to not say yes unless you mean it. If you say yes remember you are bound by your word, in
line with the LBS Renege Policy. Recruiters talk to each other.
It is not necessary to say yes in order to get an offer, but be ready to discuss what criteria would you use to
evaluate multiple offers. The criteria can highlight some characteristics that match the strengths of the firm
you are interviewing with. This is a way to show commitment without giving your word. It is also usually
advisable to mention that your main driver will be the fit with the people you meet. Banking requires long
hours, and if you do not get along with your team it can be a nightmare.

Question 25

What are our greatest weaknesses?

Answer 25

This question is rarely asked. It is designed to test your knowledge (and therefore level of interest) in the
bank. Usually it is advisable to point out some “non-dangerous” areas of improvement for the bank, such
the lack of presence in Asia or lack of leverage or their unique international footprint.

Question 26

Why do you think we selected your resume out of the hundreds that we received for an interview?
Why we should hire you instead of your classmates? Were you surprised that we called you back
for the second round of interviews?

Answer 26

Consider yourself fortunate if you get this question. It is an opportunity to sell yourself on why banking, why
this bank and why you.
Do not make the mistake of not sounding sufficiently humble. The Analyst or Associate role requires a lot of
self-confidence but also a good degree of humbleness. There will be a times when you will have to follow
the guidelines of senior bankers even if you disagree or don’t fully understand them.
Moreover, no one likes to work with overly narcissistic people. They are a problem for everyone.

Question 27

If you were not offered a position in investment banking, what other jobs would you consider?
How would you deal with a rejection?

Answer 27

There is no perfect answer. However, you are in an interview and you should show commitment and
thoughtful planning. Some non-dangerous answers may be:
- Small boutique bank in order to gain enough experience and then re-apply for a bulge bracket
- M&A/business development at a corporation
- Project finance for a lending bank
- Small cap PE fund

Question 28

Which of our competitors do you admire the most?

Answer 28

It is another question designed to test your knowledge of the market. It’s advisable to choose a bank with
similar characteristics of the one you are interviewing for.
For example a good comparable for J.P. Morgan would be Citi, highlighting their ability to cross sell
products leveraging their lending capabilities.
A good comparable for Morgan Stanley would be Goldman Sachs, saying that you really appreciate their
pure investment banking model and their culture for excellence.

Question 29

Tell me about a time you or your team succeeded/failed or your biggest achievement/failure:

Answer 29

This is part of the “tell me about a time…” questions and is supposed to show the interviewer how you
handle situations involving stress and emotions. What did you learn and what was your role?
Your answer should be tailored such that the skills demonstrated should be the ones relevant to be a good
Analyst or Associate. Good examples usually include a project that did not go as planned or a work
situation that did not develop as expected.
Avoid empty statements like my greatest failure was not getting a job at Morgan Stanley right after
undergrad. Also avoid big mistakes. It is advisable to use real situations and then show how you used the
failure to progress and learn, and how the next time you handled the same situation brilliantly.

Question 30

What are your three major strengths?

Answer 30

The interviewer is going to judge if you are a good fit for banking. Answer using the qualities described
earlier for a good Analyst or Associate.

Question 31

Tell me why I should hire you in three sentences/ what are the three words that best represent you?

Answer 31

Welcome this question as a great opportunity to talk about your unique selling points. It is a variation of the
three major strengths, but you should back-up your qualities with examples from your professional
background.

Question 32

What are your three major weaknesses?

Answer 32

This is a delicate question and you should treat it accordingly. No one is perfect, so there is no fault in
admitting it. Say a real weakness and most important tell the interviewer how you have been working on it
and the improvements you have already achieved.
However, avoid suicidal statements such as “I do not like working in teams” or “I am not good with
numbers” or “I lose control under stress”.

Question 33

If your best friend/classmates had to describe you in three words, what would they say?

Answer 33

This question is a variation of the three major strengths. The interviewer is just trying to figure out if you
would be a good addition to the team. Answer using the qualities described earlier in order to convey the
right message.
For each word you list you should also give an explanatory sentence, possibly recalling a short anecdote.

Question 34

What would someone you have not gotten along with in the past say about you?

Answer 34

Many students live these questions with anxiety. You should not, it is indeed another opportunity to sell
yourself.
It is a variant of the weaknesses question, but with the caveat that you should tell an anecdote of your past
possibly related to a misunderstanding / team working situation. For example a time when you were in charge of delivering a project for the client and one of the advisors (for example the legal) was not
delivering their work on time putting the entire operation at risk, so you had to step down and “push” in
order to make the process flow again.

Question 35

What would your ex-boss say about you?

Answer 35

This is a variation of the strengths question and represents another great opportunity to sell your unique
marketing points. Just ensure that you support your statements with real anecdotes.

Question 36

Is there any reason we should not hire you?

Answer 36

There is no right answer. It all depends on how your interview is going. You can view it as a variance of the
weaknesses question.
If the interview is going well and it appears that you would be a good fit, you can answer with a joke like “if
you did not hire me you would probably not hire at all” or “I sincerely do not see any plausible reason!” Another option is to try to think about the recruiter’s perspective. Figure out what about your profile would
worry a recruiter, and then convince them about how that is not a weakness at all. Make sure you support
your statement with a relevant story from your professional background.

Question 37

Do you have any questions for me?

Answer 37

All interviews end with this question. The worst response to this question is, I have none. The interviewer
wants to understand if you are naturally curious and can ask intelligent questions.
It is another great opportunity to show how thoughtful your research has been and how well you would you
fit in their team. Here is a suggestion on some common questions to ask:
- Interviewer background: how did you get started in banking? Why did you choose your group?
- Ask for advice: what distinguishes a good Analyst or Associate from a great Analyst or Associate?
What are the key factors that make a summer internship successful?
- Discussion: you can ask senior bankers on their view of their sector. While this is usually
appreciated, you should be prepared to discuss the topic.
While these are all good questions, you should try to use your intelligence and creativity. Final questions
are a way of differentiating yourself.

Question 38

Tell me about a time you when you showed leadership

Answer 38

You should talk about an experience when you were requested to take the lead of your team and
successfully obtained the results you waited for.
• Start by stating the situation/problem and the objective.
• Describe the team and relative roles. Explain how you delegated/managed the work flow.
• State the results of your work and the client’s reaction.
This is also a good opportunity to talk about how you manage expectations with your seniors and how you
can work well with others, try to state anecdotes and prove that you have the required skills of an Analyst
or Associate.

Question 39

Define leadership and describe your leadership style

Answer 39

There is no right answer, but a “balanced” approach is advisable. The best Associate or even Senior
Analyst is able to lead analysts and leave them with a good grade of independency but at the same time
will take responsibility/double checking (the mistakes of analysts) for delivering the output in time and with
no mistakes.

Question 40

Tell me about a time when a team did not work as intended. Tell me about a time when you
successfully resolved a conflict.

Answer 40

It is strongly recommended you use a story when a team wasn’t working until you began to fix it.
Never be negative in an interview, therefore you should avoid pointing the finger against someone in
particular.
Many students take a situation where there was a personality clash between two members of the team
(ensure you are NOT one of the two) which was blocking the workflow; and then explain how they worked
to “bridge” the two antagonist’s positions, ultimately allowing the group to deliver results.

Question 41

Are you a leader or a follower?

Answer 41

The truth is you must be both (be a balanced person!). A good Analyst or Associate must be versatile and
take the lead or take advice and follow, according to the team’s needs.

Question 42

What was the most difficult situation you faced as a leader and how did you respond? Tell me
about a time you overcame adversity/greatest challenged as a leader? Give me an example of a
leadership role you have held when not everything went as planned.

Answer 42

The answer is your opportunity to talk about a situation where you stayed calm and effectively managed
the situation.

Question 43

Do you like to work with other people? Do you want that to be part of your job?

Answer 43

As said before, of course you like it. Efficient teams achieve the greatest results and in the shortest
time.

Question 44

Tell me about a time you worked on a team. What was your role?

Answer 44

Teamwork questions are meant to test your knowledge of the work of an Analyst or Associate. They
want to know if you will work well with senior bankers, peers in different groups and analysts, in a
constant and pressing communication flow.
Many students tell about a time when teamwork was complex and eventually very successful and they
were both leader and followers in the process.

Question 45

If you are asked to deliver 3 projects for which you don’t have enough time, what would you do?

Answer 45

Martin’s example response: I’d take the one where I’m the SME (subject matter expert) and assuming that one of them is low effort high impact I’d take that one as well. For the third one I’ll delegate.

Question 46

You have never worked in finance before, what do you know about the job of an Analyst/Associate?

Answer 46

You have never worked in finance before, what do you know about the job of an Analyst/Associate?
You should acknowledge that fact, but show how much research you have carried out (including talking to
friends who work in banking etc) which means you have formed a good idea of the role and believe that
you would be a great fit. Then you should talk about what you understand the role to be.
eg. An Associate In IBD
The associate leads the execution of all the work done by the team, from the pitch to the execution of the
deal as well as acting as the coordinator of the team.
The main qualities/roles of an Associate:
- Successfully lead and coordinate with Analysts.
- Get the number rights and are technically prepared.
- Have business judgment (do not waste time of analyst by working on useless things).
- Have commercial skills when facing a client.

Question 47

What’s the work of a banker in managing an IPO?

Answer 47

In an IPO the main role of banks is to guide companies in the process to raise money from equity investors
on the public markets.
The process is lengthy and involves many steps and different actors. Bankers are in charge of the
coordination of the all process, with particular attention to the communication with potential investors. The
final responsibility of the process being in time lies always on the bankers.
In managing the IPO, banks have four main activities:
• Coordination:
- Coordination and planning of the process
- Control and monitor work streams
• Documentation/Listing filings:
- Prospectus
- Due diligence (legal, business, financial)
- Legal filings
- Documents/contracts (Underwriting agreement, legal opinion…)
• Valuation / Equity story:
- Valuation (price range)
- Equity story (why the company is a good investment?)
• Marketing:
- Offer structure (index, size)
- Communication
- Roadshow/book building
- Aftermarket (greenshoe, stabilisation)

Question 48

Tell me about a deal you have been following

Answer 48

This question is highly important, even if it is not directly asked during an interview, it can be used during
your interview and is nowhere else, you can use it during the last part of your interview when the
interviewer asks if you have any questions for them, thus prepare a recent deal that the bank has done.
This question reflects an everyday situation in banking. Often senior bankers ask analysts and associates
to scout for information on specific deals and prepare a concise summary.
However, the main purpose for this question is to understand your passion about M&A and how well you
followed the market. If you are applying for a specific sector you should cover that with particular attention.
Summarise the deal and why you think it is interesting in few sentences. Prepare a one-page deal
summary on at least 4-5 transactions. You should include the following information:
- Announcement date
- Acquirer and target description
- Enterprise Value and Equity Value
- EBITDA and PE multiples (in line with industry average? Accretive or dilutive for the buyer?)
- Structure of the deal (Cash vs stock, LBO?)
- Deal rationale (VERY IMPORTANT, remember what’s M&A all about)
- Synergies announced at transaction
- What is the impact on the industry?
- Market response
- Banks involved

Question 49

What do you think are the three most important criteria for hiring someone into this position? What
about your background will make you a good investment banker?

Answer 49

Use your story and the answer to the role of an Analyst or Associate to formulate your unique answer.

Question 50

If you can relate a sports position on a team to an Analyst/Associate’s role, what would it be?

Answer 50

If you played any sports it’s a good opportunity to link its particular skills with those required from an
analyst/associate. Build the answer around “what makes a great analyst/associate?”

Question 51

What do you expect to get from your summer experience?

Answer 51

Again, this question is a test of your understanding of the job. Many students say that you look forward to
contributing to your team and finally practicing/learning what you have been studying so hard.

Question 52

Would you rather be on the buy-side or sell-side of a transaction?

Answer 52

If it is an auction, of course you want to be on the sell-side because it is more probable you’ll earn the
success fee.
Think of an auction where 10 buyers are in competition to buy one company. The advisors on the buy-side
are going to earn the success fee only if their client ends up buying the company, while those on the sellside can sell to each one of the 10 buyers. If you had to be on the buy-side, you should prefer to be on the
side of a strategic buyer, because they’re more likely to be able to pay more, since they will generate more
synergies through the transaction than a financial buyer.

Question 53

If you had £1m, where would you invest?

Answer 53

Ask for the goal of the investors. Is it a 20% return in one year or a long-term investment looking to cover
your retirement needs?
Build the portfolio of investments around your objective. If it is a short-term capital gain you should pick a
high beta stock. Good ideas can be found from the stock pitch competition organized every year from the
Investment Management club.
Evaluate the investment, stating why you believe the industry is attractive and then why the company is
going to be able to capture value in the industry.
If the investment goal is to create returns on a 30 year time horizon, a balanced portfolio may be the best
option. Use the corporate finance class to prepare better for this question, but keep in mind that recruiters
are interested in your ability to understand clients’ need, respect limitations and understand why some
investments are better than others. Another strategy that can really help is if you have been building on your own portfolio, this can be a real
winner as you have spent time on choosing certain sectors and or companies and while doing so you have
built some understanding/rationales for the same. If you have done so, you will be able to very comfortably
answer this question and possibly win over the interviewer.

Question 54

In which sector/trend of the industry would you invest and why?

Answer 54

This is an obvious question if you are interviewing for an industry team. They want to test your
understanding and your passion for the industry, don’t miss out on this opportunity to show your
preparation.
Structure your answer by addressing:
• Why this trend is going to create or shift demand
• How the competition in the industry is likely to change
• Why M&A activity may happen as a consequence (quote a recent deal if you can)
• Returns in the sector
• Regulatory environment and possible changes in the near future
• Major players and their returns
• Future of the sector
You should pick a relevant and recent trend, and be specific.

Question 55

If you owned a business and were approached by a large multinational for selling it, how would you
make a decision on what to do?

Answer 55

Recruiters want to see how well you reason about valuing an investment. In fact, if you do not sell, it means
you are “investing” the lost price in the company. Therefore, from a pure financial point of view you expect
the present value of future cash flows to be higher than the price offered.
Of course there are other factors you would like to address, such as the cultural affinity, the governance
and the fact that you may want to retain a decisional role in the company.
From an evaluation point of view you should understand the future of your company and the potential
business plan:
• How attractive is the market?
• Is the company going to capture value in the market? This will give you an estimate of the growth
of the company.
• At what price can the company be valued in 5 years? What’s the present value? This can be done
by either looking at the intrinsic value of the company (done using DCF) or also looking at
comparable public companies or even comparable transactions in the past. Also, try to get a range
of an acceptable value for the company.
This exercise will give you the guidelines to understand how to look at the value of your company. Then
you should consider the key terms of the offer:
• What’s the price vs the combination of the value of the company calculated in the previous step
and the present value of the synergies the acquirer expects to realize
• Payment structure (cash vs stock), for a better idea of what this means, have a look at the section
on Merger Consequence Analysis.
Finally draw your conclusions.

Question 56

Enterprise Value

Answer 56

The value of the Assets of a company is given by the fact that owning 100% of the company will give you 100% of
all the future income generated from the company.
Therefore, the value on the financing side (owners of the future income) is equal to value on the assets side (you
are as rich as much it’s valued what you own). Usually companies are financed through a mix of debt and equity;
therefore the enterprise value is equal to the sum of the value of debt and the equity

Question 57

Why debt is part of the EV?

Answer 57

Think about the case you buy a house worth $100m using $70m of Debt. After one year you decide to sell the
house, which is worth now $120m, how much is the value of the equity?
You receive $120m, from the sale, but you have to repay your debts for $70m, so equity is what remains after you
repay debt: $120 - $70 = $50m. Here we go. Value of Assets: present value of the future income generated by the assets of the company.
Value of Debt: present value of the payments to debt holders less the excess cash (Net Financial Position).
Payments to interest holders include passive interests and capital repayments (think to your HSBC loan).
Value of Equity: present value of payments to equity holders (if listed, share price x shares outstanding). Payments
to equity holders include all the income left after having paid the debt holders. For this reason equity represents a
“residual” claim on the value of the company assets.
Therefore, in every valuation we will use the following equation:
Enterprise Value = Equity Value + (Debt – Cash “net debt”)
However, given that you are interviewing from LBS and have studied Corporate Finance, you need to come up with
a more sophisticated answer to this question:
Enterprise value =
common equity at market value + preferred equity at market value + minority interest at market value, if any + net
debt (debt at market value - cash and cash-equivalents) + unfunded pension liabilities and other debt-deemed
provisions
- Long term and Equity Investments – Net Operating Losses + Capital Leases
• Preferred and Minority Interest are just other types of equity and thus treated just as common equity is
treated
• Net Operating Losses – Should be valued and arguably added in, similar to cash.
• Long-Term Investments – These should be counted, similar to cash.
• Equity Investments – Any investments in other companies should also be added in, similar to cash (though
they might be discounted).
• Capital Leases – Like debt, these have interest payments – so they should be added in like debt.
• (Some) Operating Leases – Sometimes you need to convert operating leases to capital leases and add
them as well.
• Unfunded Pension Obligations – Sometimes these are counted as debt as well.

Question 58

How do I find the value of an Asset?

Answer 58

Good question, the value of an asset depends on the cash you will receive from it. But because future cash flows
are risky, we have to discount them in order to account for risk and time value of money.

Question 59

Discount Rates - how do you value something that is uncertain and in the future?

Answer 59

By using discount rates, which reflect the cost for the time value of money and the cost for remunerating the risk of
volatility of the future cash flows.

Question 60

How do you find the right discount rate for cash flows to equity investors?

Answer 60

Using the CAPM:
Return of market portfolio = Rf + Beta (Rm – Rf)

Let’s start from a basic question, what does return to equity investors compensate? It compensates for the time
value of money and for the risk of the investment.
• Time Value of Money: imagine a US govt T-bill which matures in 1 year. It is assumed to carry no risk (US
Govt will not default), but is still offering a positive return on your investment. Why? The return offered from
a T-bill (Rf) is compensating the investors for the fact that if you lend money today you will not get it back
for a year.
• Risk: risk arises from the standard deviation of the cash flow profile. As we have seen, a T-Bill carries no
risk (standard deviation = 0), because the US government is asumed to be able to pay back the exact
amount promised. However, if you are buying a market portfolio ( eg ETF on SP500), you will require a higher expected return than T-Bills since it does not offer the same certainties of return. Since there is a
higher risk that you might lose money, you want to be compensated for that by receiving a greater return.

Question 61

But how do we find out about risk and how we measure it?

Answer 61

It all boils down to the variability (standard deviation) of cash flows, which are influenced by two kinds of risks:
• Unique project risk: These are the risks associated with the fact that there are some perils which threaten
the success of an individual company but not necessarily the economy in general (management, plant
failure, etc.)
• Market risk: These are the risks arising from the fact that there are economy wide perils which threaten all
businesses (nuclear meltdown, recession, FED interest rates…)

Question 62

Good, but should investors be worried about both types of risk?

Answer 62

If you own only one stock in your portfolio, of course the unique project risk is going to be important, but if you own
more than 20 stocks, you are going to worry more about the covariance of the stocks of your portfolio (market risk).
Think in the following way: if the specific risk of each stock is idiosyncratic, it means that it moves randomly. If each
specific risk in your portfolio moves randomly it means that their net effect will be zero (one stock goes up and
some other goes down, net effect averages zero).
Therefore, for a reasonably well-diversified portfolio, only market risk matters since it influences all your stocks in
the same direction. This is the risk you can’t diversify. That is why stocks have a tendency to move together, and
that’s why investors are exposed to market uncertainties, no matter how many stocks they hold.

Question 63

Which risk should then be remunerated?

Answer 63

As we have just seen, the risk of a well-diversified portfolio depends only on the market risk of the securities
included in the portfolio, in others words from the covariance of the stocks with the market portfolio. Why the market
portfolio?
Because market risk is by definition measured by the movement of the market portfolio (SP500 for example).

Question 64

Great, and how do I measure the market risk of a stock?

Answer 64

You simply measure how sensitive it is to market movements. The sensitivity of an asset to the market is called
beta. Stock with betas greater than 1.0 tend to amplify the overall movements of the market. Stocks with betas
between 0 and 1.0 tend to move in the same direction of the market, but not as far. Of course the market is the
portfolio of all stocks, so it has a beta of 1.0.
Example: a stock with a beta equal to 1.20 will amplify market movement by a factor of 1.2 (market movement
+10%, the stock will perform +12%).

Question 65

How does CAPM find the required return?

Answer 65

CAPM states that the return required by equity investors in order to invest in a stock, is a function of the market
return and its sensitivity with it (remunerates only non-diversifiable risk).
Required return for stock A = Rf + BetaA (Rm – Rf)
Rf = Risk free
Rm = Return on the market portfolio
Beta A = Beta of company A

Question 66

Ok great; we have just seen how the value of a company is equal to the present value of the future cash
flows it will pay. But how does a company generate value for its shareholders?

Answer 66

As easy as that, it should generate a return higher than the required return by investors. In doing so it will become a
positive NPV investment and its stock price will appreciate.

Question 67

What if a company can’t deliver the required rate of return?

Answer 67

Investors will discount expected cash flows with the required return, thus achieving a lower valuation. Stock price
will go down in order to align it with the required rate of return.

Question 68

We talked about discounting the cash flows, but what exactly are we discounting?

Answer 68

That depends on what you want to value. A company produces Revenues through its business activities on an
ongoing basis. Then it pays all the operating costs, taxes and makes important investments decisions for the future.
What remains is called “unlevered” cash flow, which is not influenced by how the company is financed. However, the financing mix dictates how this cash flow is then divided among holders of rights on the company. If
there is debt, debtholders have a fixed claim and get paid first. What is left goes to equity holders.
So, if you discount the cash flows to debtholders using the debt discount rate, you will find the value of the debt.
In the same vein, if you discount the cash flow to equity holders using the CAPM discount rate, you will find the
equity value. Adding the value of debt and equity will give you the enterprise value.
However, what do you derive if you discount the unlevered cash flows? You will get directly to the Enterprise Value,
but of course the discounting rate will be the weighted average of the cost of debt and the cost of equity (CAPM),
which is called WACC (Weighted Average Cost of capital)
The formula of the WACC is:
WACC = Rd (1-tc) * D/EV + Re * E/EV

Question 69

How would WACC change if debt were to go up? How would WACC change if tax rates were to go up?

Answer 69

These are the category of questions, which are derived from the formula given above, so if debt were to go up, given that it is a cheaper source of capital, WACC would go down. Now answering the second question, if tax rates were to go up, WACC would go down as the after tax cost of
capital has come down. Thus, remember the formula and also reason what the effect of each component of
WACC’s formula is on WACC and why.

Question 70

How would you find the WACC of a private company with no debt?

Answer 70

Firstly, here WACC is simply the cost of equity or in other words how much should the equity sponsors be
compensated for taking on the business risk of the company. The answer lies in looking at similar companies on
the basis of the following criteria:
• Industry
• Size
• Geography ….

Question 71

What is an Income Statement? What are the major line items on it?

Answer 71

The income statement provides the results of a business’ operations during a specified period of time.
• Revenues: Income that arises from the sales of goods and/or services and is recorded when it’s earned.
• Expenses: Commonly includes COGS, SG&A, D&A, Interests and Taxes, which are the costs a business
incurred over a specified period of time to generate the Revenues reported.
• Net Income = Revenues minus expenses.

Question 72

What is Revenue?

Answer 72

Sales (or Revenue) is the first line item, or “top line,” on an income statement. Sales represents the total dollar
amount realized by a company through the sale of its products and services during a given time period.Sales levels and trends are a key factor in determining a company’s relative positioning among its peers. All else
being equal, companies with greater sales volumes tend to benefit from scale, market share, purchasing power,
and lower risk profile, and are often rewarded by the market with a premium valuation relative to smaller peers.
Revenue = Units Sold * Price

Question 73

What is COGS?

Answer 73

Cost of Goods Sold includes all the costs directly related to the production of products and services, such as raw
materials, direct labours, plant costs.

Question 74

What is Gross Profit?

Answer 74

Gross profit is the profit earned by a company after subtracting COGS. As such, it is a key indicator of operational
efficiency and pricing power, and is usually expressed as a percentage of sales for analytical purposes.
Gross Profit = Revenue – COGS
Gross Profit % = Gross Profit / Revenue

Question 75

What is SG&A?

Answer 75

Selling, General & Administrative Expense usually refers to all the “central” costs, and includes expenses such as
salespersons’ salaries and commissions, advertising and promotion, travel, office payroll and expenses, and
executives’ salaries.

Question 76

What is EBITDA?

Answer 76

EBITDA = Revenues – COGS (not including depreciations of plants) – SG&A (not including amortisation)
EBITDA Margin = EBITDA / Revenue

It refers to Earnings Before Interests, Taxes, Depreciation and Amortisation. It is generally considered a proxy of
the operating cash flow generation of a company, but does not include change in working capital, capex, principal
repayment’s and dividends.
EBITDA is widely used for financial analysis and valuation and is considered a proxy for operating cash flow since it
reflects the company’s total cash operating costs for producing its products and services. In addition, EBITDA
serves as a fair “apples-to-apples” means of comparison among companies in the same sector because it is free
from differences resulting from capital structure (i.e., interest expense), tax regime (i.e., tax expense) and
accounting policy (D&A). [However, you will also find advocates who prefer using EBIT as they believe that the
company’s investment in CAPEX is an indicator of the future growth of the company, and one such advocate is
Warren Buffet]
It is also considered a good indicator of the ability of the company to generate profits, because it measures the
profitability of the company after having paid all the operating costs. However, it does not include the cost of the
tangible and intangible assets which for, particular industries such as Telecom, could be significant. In these cases
analysts often use EBITDA-Capex
You should also remember that even EBITDA can be influenced by individual company accounting decisions
(revenue recognition, unjustified rise in account receivables, etc…).

Question 77

What is EBIT?

Answer 77

EBIT = Revenues – COGS (not including depreciation) – SG&A (not including amortisation) – Depreciation –
Amortisation
EBIT Margin = EBIT / Revenue
EBIT refers to earnings before interests and taxes and is commonly referred as “operating profit”.
EBIT is generally considered a proxy of the operating profitability of a company and it is independent by the capital
structure (before interest). It is used to compare companies, but as it includes non-cash expenses (D&A), it can be impacted by particular accounting policies of the company. Since those policies may differ from company to
company, comparability may be affected.

Question 78

What is Net Income?

Answer 78

Net income (“earnings” or the “bottom line”) is the residual profit after all of a company’s expenses have been
subtracted. Net income can also be viewed as the earnings available to equity holders once all of the company’s
obligations have been satisfied (e.g., to suppliers, vendors, service providers, employees, utilities,
lessors, lenders, state and local treasuries). Wall Street tends to view net income on a per share basis (i.e., EPS).

Question 79

What is a balance sheet? What are the major line items on it?

Answer 79

The balance sheet is a snapshot of the financial position and the economic resources of a company.
• Assets: resources that a company uses to operate its business
o Current Assets: assets that could reasonably be expected to be converted in cash within one year.
These are important because they fund day-to-day operations. Include mainly receivables,
inventory, cash & equivalents.
o Long-Term Assets: assets which are not liquid, such as Plant & Equipment.
• Liabilities: claims that creditors and shareholders have on company resources:
o Current Liabilities: include both operational (payables) and financial obligations due within one
year.
o Long-Term Liabilities: include both operational (payables) and financial obligations not due within
one year.
Shareholders’ Equity: the book value of the equity of a company. It comprises the original “paid-in” capital plus
any subsequent issues of new equity plus the retained earnings less the dividends, which “flow through” from
the income statement each period

Question 80

Describe the three main parts of the cash flow statement

Answer 80

Net Income
\+ Non Cash Expenses (D&A)
- Change in Working Capital
Cash from Operating Activities: Cash flows related to producing and delivering goods/services
- Capital Expenditure (Capex)
\+ Disposals
- Acquisitions
Cash from Investing Activities: Cash flows related to acquiring or disposing of long-term assets
 \+ Issue of Debt
- Repayment of Debt
\+ Issue of Equity
- Dividends and Buy-backs
Cash flows from Financing Activities: Cash flows related to obtaining cash from lenders and shareholders,
and repayments of amounts borrowed.

Question 81

What is Enterprise Value?

Answer 81

Enterprise value is the value of the assets of the company. It reflects the discounted future cash flows to all
claimants, whereas equity value reflects the discounted future cash flows only to equity holders.
Since the assets side of a balance sheet must be equal to the liabilities side, we can derive that EV is equal to the
value of all the financing instruments emitted by the company (ie bonds).:
EV = Equity Value + Net Financial Position + Minority Interests + Preferred Stock

Question 82

What is Equity Value (market cap)?

Answer 82

Equity Value (“market capitalization”) is the value represented by a given company’s basic shares outstanding plus
“in-the-money” stock options, warrants and convertible securities (called fully diluted shares outstanding). It is calculated by multiplying a company’s current share price by its fully diluted shares outstanding.
Equity Value = Share price * Fully Diluted Shares Outstanding

Question 83

How do you find the number of Fully Diluted Shares Outstanding?

Answer 83

A company’s fully diluted shares are calculated by adding the number of shares represented by its in-the-money
options, warrants, and convertibles securities to its basic shares outstanding.
The incremental shares represented by a company’s in-the-money options and warrants are calculated in
accordance with the treasury stock method (TSM).
The TSM assumes that all tranches of in-the-money options and warrants are exercised at their weighted average
strike price with the resulting option proceeds used to repurchase outstanding shares of stock at the company’s
current share price.
In-the-money options and warrants are those that have an exercise price lower than the current market price of the
underlying company’s stock. As the strike price is lower than the current market price, the number of shares
repurchased is less than the additional shares outstanding from exercised options. This results in a net issuance of
shares, which is dilutive (ie, it increases the outstanding share count)
If the CEO of a company owns 100 call options with a strike price of $18 and the current stock price is $20, the
CEO will pay the strike price to the company 100$18 = $1,800 in order to exercise these options. The company
receives the money but has the obligation to give to the CEO 100 shares (which are worth $20 each). Therefore, it
uses the $1,800 to buy shares on the market. $1,800/$20 = 90 shares, but it has to give to the CEO 100 shares, so
it has to issue the difference: 100-90 = 10 shares, which is the addition to account for the dilution of the in-themoney options.
Treasury Method (New Shares)= ((Share Price – Strike Price) / Share Price) Number of Options

Question 84

What’s the difference between common stock and preferred stock? How do they trade relative to each
other?

Answer 84

Preferred stock are shares with a guaranteed dividend, while common stock are not. Moreover, in case of
bankruptcy, preferred stock shareholders have priority over the commons stock.
As a result, they have claims on the same cash flows, but just as debt usually requires a lower cost of capital (Rd)
than the cost of equity (Re) because it has a precedence on being satisfied, so preferred stock cash flows are a
little safer than common and so returns will be lower than those offered to normal shareholders.

Question 85

What are Minority Interests?

Answer 85

Minority interest occurs when one company purchases a controlling stake in another but does not acquire 100% of
the Equity. Due to consolidation accounting, however, even if you acquire only 70% of a company, the acquiring
company will recognize 100% of the acquired company’s assets and liabilities on its own balance sheet. Minority
Interest is the line item on the balance sheet where you will net out the 30% you do not own.
Let’s say LBS is listed and buys 90% of the shares of Columbia, what happens to the 10% that they did not buy?
The Columbia shareholders become minority shareholders and keep their 10%.

Question 86

Why is Minority Interest not included in the Equity Value calculation (market cap)?

Answer 86

Think about if from a cash flow perspective. 10% of the cash flows coming from the subsidiary are owned by
minority shareholders, not regular shareholders. So you can’t have what is not yours… but it is still part of the
enterprise value, which is the present value of all cash flows discounted for the appropriate WACC.

Question 87

If one of your clients had some extra cash, how would you tell him to invest it?

Answer 87

First of all we should define “extra cash” (keeping in mind that the industry maybe cyclical, and what is extra cash in
one period may be necessary in the next). Every business requires some level of cash and working capital to run
operations on a day to day basis. Anything that is not required to meet these day-to-day cash flow obligations is
excess cash. If the managers have positive NPV investments they should undertake them by definition. If they do not have where
to invest they should return money to stockholders via dividend or stock repurchase.
They may also repay debt, but only if this would be useful to move the D/E ratio toward the optimal ration (minimise
the WACC thanks to tax shield).

Question 88

In a tax free world, if you have a company with an Enterprise Value of $10bn and you issue $2bn in
debt, what is the new EV?

Answer 88

This question represents the type of questions where the interviewer is trying to test your ability to connect the
three statements, so try to work with the interviewer one statement at a time. In this question, it is just the balance
sheet, issuing $2bn in debt increases the assets side of $2bn of cash, but also the liabilities side for $2bn of cash.
So the net effect is zero, value is $10bn.

Question 89

What if after issuing the debt you use the $2bn to pay a dividend?

Answer 89

If the company uses the cash raised with the debt to pay a dividend, equity goes down by $2bn. The firm value
therefore remains at $10bn. Remember that the value of a company depends only on its future cash flow and the
return on assets. Capital structure matters only if there is a tax shield on debt or for the present value of financial
distress.

Question 90

What if, instead of paying a dividend, the Company uses the $2bn to invest in a new project with an
NPV of $3bn?

Answer 90

Enterprise Value increases by the NPV $3bn and the Investment $2bn, therefore of $5bn. New firm value is $15bn.

Question 91

Why do you subtract cash in the formula for Enterprise Value?

Answer 91

In an acquisition the buyer would “get” the cash of the company, so effectively it is paying a price minus the cash
he will receive back once he becomes the owner.
Theoretically, it’s not very accurate since one should only subtract the “excess cash”, the amount of cash the
company has above the minimum needed to fund its operations.

Question 92

In a world with taxes, if you issue debt for $100 and pay it out as a dividend, how does it affect your
EV? Ignore the present value of financial distress.

Answer 92

Simply speaking, you are decreasing the amount of equity in the company by increasing the amount of debt in the
company, thus the presentation of debt (cheaper source of capital and also having a tax shield) has increased and
presentation of equity has decreased, thus enterprise Value increases by the PV of the tax shield generated by the
new debt (please refer to the APV method of calculating the enterprise value of the company for a better
understanding).

Question 93

Could a company have a negative equity value?

Answer 93

No, but it could be zero if the value of the assets are lower than the value of the debt. You can’t have a negative
share price or a negative number of shares outstanding.

Question 94

Can a company have a negative enterprise value?

Answer 94

Yes, a company can have a negative enterprise value if the company has loads of cash.

Question 95

Why are some stock options relevant to valuation?

Answer 95

Unexercised, in-the-money options represent implicit equity value that will dilute current shareholders.
Theoretically, it should already be reflected in the company share’s price.

Question 96

When looking at establishing the price of a company, do you pay more attention to the Enterprise Value
or the Equity Value?

Answer 96

Enterprise Value, since it represents the present value of all the future cash flows generated by the real assets of
the firm.

Question 97

How do you value a company?

Answer 97

There is almost a 100% chance that you will be asked this question, so please pay extra attention to each method
and also how one is different from the other. To value a company you can create a football field showing the results
of main Valuation methodologies:
• Discounted Cash Flows: measures the “intrinsic value” of a company by discounting to the present value
all the future cash flows of the firm available to stakeholders. This can be done using the WACC or APV.
• Public Comparables: measures “relative value”, looks at a group of listed peer companies to understand
how the market values companies in the same business or industry along relevant metrics, such as
EV/EBITDA and P/E. You might use different metrics depending on the industry.
• Acquisition Comparables: Analyses which prices and multiples companies in the same business or
industry have been bought and sold historically.
• Accretion/Dilution analysis: it is an affordability analysis of what the acquirer can pay rather than an
analysis of the value of the target.
• Leveraged Buyout: indicates how much a financial sponsor should pay a company given a targeted IRR,
the debt capacity of the firm and an exit hypothesis.
Another two methodologies are also widely used to frame the value of a company:
• Liquidation Value: Examines how much the assets of the company are worth if sold on a stand-alone basis
and used in potential distressed situations.
• 52 week Trading Range: if the company is listed, then market valuation is an important benchmark

Question 98

Which valuation methods tend to lead to the highest valuation?

Answer 98

To be honest, there exist many versions to this question; however, following is the most highly accepted answer
during the recruitment season for 2012 interns:
• DCF tends to give the highest valuation as this valuation is generally based on the estimates (growth) by
company and for obvious reasons, every company would want to get the highest valuation and thus get
the maximum price.
• Acquisition comparables tend to give a higher valuation than public comparables because strategic buyers
generally generate synergies in an acquisition, which will drive a higher valuation. In addition, there is also
an acquisition premium to public comparables because the acquiring entity will win control of the company
and will now have access to that company’s cash flows (a public shareholder can’t decide how to allocate
cash flows)
• Leveraged Buyout Valuation (LBO) will be driven by financing terms available in the market.
• Public Comparables tends to lead to the lowest valuation

Question 99

What are the pros and cons of each method?

Answer 99

• DCF it is probably the best measure of the “intrinsic value” of a firm as it discounts the unlevered free cash
flow of the company by its cost of capital. It takes into account the synergies, management expectations
and the tax shield generated by the desired capital structure. However, DCF is extremely sensitive to
changes in its assumptions, in particular on growth expectations and discount rates. Moreover, the WACC
method works only if the capital structure (D/E) doesn’t change, otherwise you must use the APV method.
Finally, it is “subjective” because it reflects only your view.
• Public Comps have the great advantage of showing the market valuation/expectations on companies in the
same business. The main disadvantage is that depends on the availability of good peers and it relies only
in public information. It also does not include a control premium which would be relevant in you are trying to
value the company for purposes of an acquisition.
• Deal Comps show how valuation in M&A transaction for companies in the same business has evolved in
the past. However it suffers of the same comparability problem of public comps, exacerbated by the often lack of information on the deal. Moreover, M&A transactions are cyclical (move in waves), tend to respond
to shocks in the industry (include a strategic premium) and include synergies that are very hard to
extrapolate.
• Leveraged value is basically a DCF with special conditions. It gives you the value that a financial sponsor
can pay given a certain business plan, an exit multiple and a targeted IRR.

Question 100

Walk me through a DCF

Answer 100

To create a DCF valuation involves 5 steps:
• First, you look at the financial statements of the target in order to derive the historical financials such as
Revenue, COGS, SG&A, EBITDA, CAPEX, Change in Net Working Capital, D/E, etc.
• Second, project financials (usually 5-10 years) in order to derive future cash flows available to both
debtholders and shareholders (unlevered FCF) for the business plan period. There are two ways to
extrapolate FCF, both give you the same result:
• Third, find the right discount rate. Bankers often use the WACC, which is very convenient when you use a
long-term D/E and you don’t expect the capital structure of the company to change dramatically.
Where Re is the Return required by equity investors (CAPM), Rd is the cost of debt, Tc is the marginal tax
rate, and D/E is the long-term capital structure for the company.
If the D/E ratio is expected to change dramatically you need to use the APV method. Basically you first
calculate the value of the company as if it were all equity financed (WACC = Re if there is no debt) and
then you add the present value of the tax shield created by interest expense and subtract the present value
of the financial distress.
• Fourth, determine the Terminal value of the company, in other words the present value of all the future
cash flows after the least year of projections/business plan. There are three ways to find the TV:
o Gordon Growth Model (Perpetuity formula): present value at the last year of projections of
an infinite series of cash flows growing at g and discounted at WACC. Perpetuity growth is
obviously highly sensitive to the long-term growth assumptions, which is usually calculated
between inflation and long-term GDP growth (2-5%).
METHOD 1 METHOD 2
EBITDA Net Income
- D&A + Interest expense * (1-Tc)
EBIT + D&A
- Taxes - Capex
NOPLAT - Increase in Working Capital
+ D&A Unlevered Free Cash Flow
- Capex
- Increase in Working Capital
Unlevered Free Cash Flow
FCF (last year) * (1+g)
WACC - g

o Exit multiple: terminal value is most commonly calculated as a multiple of the EBITDA or
EBIT in the last year of projections. Of course, a high EBITDA multiple implies high growth
expectations. The multiple you use is generally based on the average multiple observed for
companies of this type in the public market (ie, from your public comparables analysis)
o Liquidating value in the terminal year (used for example in mining)

• Fifth, obtain the Net Present Value of the company by discounting to today using the WACC the cash flows
for the year of projections and the terminal value.

Question 101

Walk me through how you get from Revenue to Unlevered Free Cash Flows. And to cash flows to
equity holders?

Answer 101

METHOD 1
Revenue
- COGS
Gross Profit
- SG&A
EBITDA
- D&A
EBIT
- Taxes
NOPLAT
\+ D&A
- Capex
- Increase in Working Capital
Unlevered Free Cash Flow
- Interest expense * (1-Tc)
- Principal repayments
Free Cash Flow to Equity

Question 102

What percent of the company NPV is usually in the Terminal Value?

Answer 102

The terminal value typically accounts for a substantial portion of a company’s value in a DCF, sometimes as much
as three-quarters or more. Therefore, it is important that the company’s terminal year financial data represents a
steady state level of financial performance, as opposed to a cyclical high or low. Similarly, the underlying
assumptions for calculating the terminal value must be carefully examined and sensitized.
The weight on the value depends mainly on:
• Length of projections period before using the TV (visibility of the business)
• Long-term growth rate (g) used to calculate the TV. Note that if you used the exit multiple method, your
assumption would be the same. A high multiple corresponds to a high growth rate, and you can always
calculate the implied perpetuity value to an exit multiple value by finding the g where the two values are
equal.

Question 103

Why would you use (1+g) in the Terminal Value?

Answer 103

Mathematically, (1+g) grows the last projected year out another year (to the first year of the perpetuity method).
Why? The simple formula without (1+g) is: FCF / (WACC-g) says: “give me a constantly growing stream of cash
flows that starts at the end of the year and I will give you the value of that cash flow stream at the beginning of the year. However, you need the present value of the cash flows to fall at the end of the last projected year, not at the
beginning.

Question 104

What is an unlevered cash flow?

Answer 104

A business generates cash through its daily operations of supplying and selling goods and/or services. Some of the
cash has to go back into the business to renew fixed assets and support working capital. If the business is doing
well, it should generate cash over and above these requirements. Any extra cash is free to go to the debt and
equity holders. The extra cash is the free cash flow to stakeholders.

Question 105

Why does DCF use unlevered cash flows?

Answer 105

Unlevered free cash flows are generated by the use of the company real assets, disregarding the company
financial structure (D/E). Therefore, discounting unlevered cash flows will give you the enterprise value of the whole
company.
If, however, you discounted the cash flows to debt holders by the cost of debt you would be able to find the value of
the Debt, while if you discount the cash flows to equity holders by the cost of equity you would be able to find the
value of Equity. The unlevered free cash flow is equal to the sum of cash flow to debt holders and the cash flow to
equity holders.

Question 106

How do you get to the free cash flow to equity holders?

Answer 106

There are two ways to extrapolate FCF to equity holders, both give you the same result:

METHOD 2
Net Income
\+ Interest expense * (1-Tc)
\+ D&A
- Capex
 - Increase in Working Capital
= Unlevered Free Cash Flow
 - Interest expense * (1-Tc)
 - Principal repayments
= Free Cash Flow to Equity

Important note: you should know both ways of calculating FCFs as the interviewer might be bored of hearing
one kind and then might want you to tell him the other ways, so be prepared, this happened to me.

Question 107

What is the WACC?

Answer 107

WACC is the Weighted Average Cost of Capital of a company including the tax shield generated by the taxdeductible nature of interest. It reflects the riskiness of the cash flows you are discounting and can be seen as an
opportunity cost of capital or what an investor would expect to earn in an alternative investment with a similar risk
profile. For example, a large utility company should have a lower cost of capital than a more risky start-up in social
media.
Most companies use a combination of debt and equity to finance their assets; therefore their cost of capital will be a
combination of the cost of debt adjusted for the tax shield and the cost of equity. WACC is the combined, weighted
cost of debt and equity:
Debt
Total Capital
WACC = * Cost of Debt * (1-Tax Rate) +
Equity
Total Capital
* Cost of Equity

Cost of Equity = is the return required by equity investors, which is dependent by the riskiness of the cash flows
(Return on Assets) and the financing mix (D/E).
Cost of Debt = yield to maturity implied by the trading price of a company publicly traded debt.
D/E = Long-term ratio of the company, usually in line with the industry and the long-term strategy of the
management. In the absence of explicit company guidance on target capital structure, the banker examines the
company’s current and historical debt-to-total capitalization ratios as well as the capitalization of its peers.
Tax Rate = use the marginal tax rate, not the effective.

Question 108

Why do you put tax savings from interest in the WACC?

Answer 108

The WACC uses the after tax cost of debt because unlevered free cash flows do not include the effect of interest
when you calculated taxes. However, most businesses have debt and interest payments, and the WACC picks up
the tax savings from interest payments.
The idea is that because interest payments are tax-deductible, the cost of debt to the firm is actually lower than the
stated coupon. (p.60 LBS guide, TBC)