Investment Banking Q&A Flashcards
What is high yield debt?
A bond that is rated below investment grade and government bonds. These bonds have a higher default risk and thus command a higher interest rate.
What is unsecured debt?
Any type of debt obligation not secured by some assets.
What are ABL Facilities?
Asset based lending. A loan that is secured by assets as collateral.
What is a Revolving Credit Facility?
Revolving credit is a line of credit where the customer pays a commitment fee and is then allowed to use the funds when needed. It is like a credit card and is used by companies to fund working capital.
What are Senior Bank Loans?
Underwritten by an investment bank and syndicated to institutional buyers. First priority in bankruptcy. Often secured in case of liquidation by company’s assets. Usually have a floating rate based upon LIBOR.
What is Mezzanine Debt?
The basic forms of mezzanine debt are subordinated notes and preferred stock. Usually has a kicker where mezzanine investor can buy a portion of ownership later if desired. Helps fill the gap between senior debt and equity when financing a deal. Say you want to buy a company for $1,000,00 and can pay $200,000 in equity while the rest is covered with normal debt, but you want to pay less equity to try and boost returns? In this case, you might call upon a mezzanine investor so that you don’t have to put $200,000 down.
Why would a company use bank debt rather than high yield bonds?
Bank debt is secured by assets of a company and therefor commands a lower interest rate. Trade off is that bank debt typically has more covenants and restrictions.
When should a company issue equity, rather than debt?
1) Feels the stock price is inflated
2) If new projects may not produce consistent cash flows
3) If company wants to adjust capital structure or pay down debt
4) If senior executives are looking to “cash out”
What are some of the advantages of debt financing?
1) Doesn’t dilute ownership (control)
2) Don’t forgo future profits
3) Tax Shields!
What is PIK interest?
Paid in Kind. Rather than making cash interest payment, the bond/loan will increase in the face value each period by the PIK interest rate.
Why is debt cheaper than equity?
Once you pay off debt the obligation is over, but with equity the obligation is infinite. If you expect the company to perform well than it will likely be more expensive.
What is Amortization?
A feature that may be built into a loan requiring the borrower to pay off the loan over its term rather than paying the entire face value at maturity.
What steps can the Fed take to influence the Economy?
1) Open Market Operations (buying/selling securities to change the money supply)
2) Raising or Lowering Rates
3) Change Reserve Requirements (lower requirement = more loaning)
What is duration?
Measure of sensitivity of the price of bond to a change in interest rates. It is essentially the weighted average maturity of cash-flows over the price of the bond. Measured in years. Main flaw is that it assumes a linear yield-price relationship.
How would you describe the difference between leveraged finance and debt capital markets?
Leveraged Finance typically works with sub-investment grade, high-yield debt instruments where DCM team works with investment grade debt.
The focus of Leveraged Finance are LBO/Acquisitions where DCM is more everyday operations of businesses (although acquisitions also)
Can a company have a negative book equity value?
Yes if giving out large dividends or operating at a loss for a long time
What is Debt-Service-Coverage Ratio?
A leverage ratio equal to Net Operating Income divided by total Debt Service.
A ratio beneath 1.25-1.5 is deemed low (depending on industry)
What is Gross Profit Margin?
A profitability ratio:
= Gross Profit / Revenues
Represents proportion of money left over from revenues after COGS
What is Operating Margin?
A profitability ratio:
= Operating Profit (EBIT) / Revenue
Provides a metric for how much a company makes (before interest and taxes) on each dollar of sales
What is Net Profit Margin?
A profitability ratio:
= Net Income / Revenue
Shows percentage of each dollar in revenue that gets converted into profits
If depreciation is a non-cash expense, why does it affect the cash balance?
It is tax deductible, since taxes are cash expense it has impact on cash flow statement.
Impact = depreciation amount * (1-tax rate)
What happens when inventory increases by $10? Assume you pay with cash.
Income Statement: nothing
Cashflow Statement: decrease cashflow from operations by $10
Balance Sheet: Inventory is up $10 and Cash is down $10
What happens to the three statements when there is a write-down of $100?
Income Statement: $100 write-down shows up on pretax income, with 30% tax rate Net Income decreases by $70
Cashflow Statement: Net Income is down $70, but we add back $100 since the write down is a non-cash expense, overall up $30
Balance Sheet: Write down is decrease in assets by $100 and cash is up $30. Overall down $70 and shareholders equity down $70
A company has had a positive EBITDA for the past 10-years but recently went bankrupt, how could this happen?
1) Spending too much on capital expenditures
2) Company has high interest expense and can’t afford debt
3) Debt all matures at one time and they have a credit-crunch
4) Has significant one-time charges such as a litigation fee
What is the difference between bottom-up vs top-down revenue building?
Bottom-Up: start with individual products/customers, estimate the average sale value or customer value, then growth rate and sales and project from there
Top-Down: start with big-picture metrics such as overall market size, estimate company’s market share and how it will change moving forward, multiply to get revenue
What is the Debt Capital Market?
A low risk capital market where investors are lenders to company in exchange for debt securities. These markets also used by companies to finance themselves through debt which helps diversify funding.
How does one acquire debt securities?
1) Primary Market: where government/corporations directly issue bonds
2) Secondary Market: where individuals who have already received there bond certificates go to resell bonds for higher/lower price (subject to demand)
What are the differences between DCM and ECM?
In Debt Capital Markets investors are lending money to companies where as in Equity Capital Markets investors are purchasing a portion of ownership
Debt Capital Markets usually has lower risk, lower return
In Debt Capital Markets investors expect payments in full, can’t be said for Equity Capital Markets
What is the difference between a Corporate Bond and a Consumer Loan?
Main difference is market they are traded on, bonds are issued and traded on secondary markets
Bond issuance typically for a large amount of capital, is sold on the public market and can be traded
A loan is issued by a bank, usually has floating rates, covenants and is not traded
What is a coupon payment?
The interest payment a company will pay to holders of the bond loan
= interest rate * face amount of bond
What is the difference between an investment grade bond and junk bond?
Investment grade bonds are issued by companies with good credit ratings and low risks of defaulting. Therefor, they have a relatively low rate because they are “safe”.
Junk bonds are issued by a companies that have high risks of bankruptcy but thus has higher interest payments.
How could inflation hurt creditors?
Inflation cuts into the real percentage return that creditors make when they lend money
What is the Current Ratio?
= Current Assets / Current Liabilities
A number slightly above 1.00 means that they are managing inventory efficiently
A ratio below 1.00 means that they are struggling to meet liabilities, whereas a ratio well above (2-3) means that they may not be using enough leverage to expand business
What is the Interest Coverage Ratio?
= EBIT / Interest Expense
Measures a company’s ability to make its annual interest payments with its casfhlows
What is the Leverage Ratio?
= Total Debt / EBITDA
Allows an investor to evaluate how many years of cash-flow it would take for a company to retire its debt
What is Convexity?
The main issue of Duration is that it assumes a perfectly linear relationship between bond yield and price. Convexity is the answer to this problem.
Convexity measures the relationship between bond prices and bond yield. The higher the convexity, the greater the impact interest rate fluctuations have on a portfolio, and the greater the overall risk.
Which is riskier, a 30-year coupon bond or a 30-year zero coupon bond?
A zero coupon bond yields $0 until the maturity date, and is thus considered riskier.
Ways in which the three financial statements are connected?
1) Net Income from the IS flows into cash flow from operations on the CS statement
2) Net Income - Dividends (IS) is added to retained earnings from prior periods balance sheet to come up with current retained earnings
3) Beginning cash on the CF statement comes from old BS and now cash is from current BS
Major Lines of Income Statement
Revenues
(Cost of Goods Sold)
Gross Margin
(Operating Expenses)
Operating Income (EBIT)
(Interest Expense)
(Other Expenses)
(Taxes)
Net IncomeMajor lines of Casfhlow Statement?
1) Cashflow from Operations: $ generated or lost through normal operations
2) Cash from Investing: $ generated or lost through investments (cap ex, assets)
3) Cash from Financing: $ generated or spent on financing business
What is Net Debt?
Net Debt is a company’s total debt minus cash it has on the balance sheet. Net Debt assumes that a company pays off any debt it can with excess cash on balance sheet.
= Enterprise Value - Equity Value
What are the most important valuation methods?
1) Sales Comparables
2) Precedent Transactions
3) Market Capitalization
4) Discounted Cashflow Model
5) Leveraged Buyout Model
Explain briefly the “sales comparables” valuation method?
Step 1: Select comp companies (market, geography, industry, time)
Step 2: Calculate market cap
Step 3: Calculate Enterprise Value
Step 4: Find multiple (4x whatever…)
Step 5: Use multiple and comps to estimate range of values
Common Multiples: EV / EBITDA
Note: use enterprise value unless tax expense is included (which case use equity value)
What is the formula for Enterprise Value?
EV = Market Cap + Net Debt + Preferred Stock + Minority Interests - Cash
How do you determine the discount rate of a bond?
Discount rate is determined by the underlying company’s default risk:
- Credit Rating
- Volatility of casfhlows
- Interest rate on comparable US bonds
- Current debt outstanding
- Leverage ratios…
How do you price a bond?
The price of a bond is the net present value of all of their future contraflows expected from the bond using the current interest rate
If you believe interest rates will fall, and you are looking to make money due to the capital appreciations on bonds, should you buy or short sell them?
Buy them! If you believe interest rates will fall, then you believe prices will rise. Buy them now and make gains on capital appreciations!
What would cause the price of a treasury note to rise?
If the stock market is extremely volatile and investors are fearful of losing their money, they will desire “risk-free” securities (gov. bonds)
What is an FX Forward?
An agreement to purchase or sell a set amount of a foreign currency at a specified price for settlement and predetermined time in the future.
Used to help mitigate risks in the currency markets.
What is the default premium?
The default premium is the difference between the yield on a corporate bond and the yield on a government bond with the same time to maturity. It is how big the gap in rates must be to compensate for default risk.
Why might two bonds with the same maturity, coupon, issuer be trading at different prices
Some other difference such as:
1) Callability
2) Putability
3) Convertible
What is the yield to maturity (YTM) on a bond?
YTM is the rate of return of a bond if it is purchased today for its current price, held through maturity date and paid-in-full
What is a Eurodollar bond?
A bond issued by a foreign company but in U.S. dollars
What does it mean when a bond is callable?
Allows the issuer to “buy back” the bond on a certain date / dates prior to maturity
Issuer must pay premium to call it early
What does it mean when a bond is putable?
Gives the owner of the bond the right to force the issuer to buy back the security prior to maturity
Opposite of callable
What is a convertible bond?
A convertible bond can be turned into equity in the bonds lifetime. The bond can be converted before maturity should the bondholder decide that equity in the company is worth more than the bond.
Walk me through a brief overview of a DCF model?
1) Project Free Cash Flow for 5-10 year period
2) Determine “terminal value” and project free cash flow for beyond 10 years
3) Calculate WACC
4) Discount it all bank
What is the equation for Free Cash Flow?
FCF = EBIT * (1 - tax rate) + D&A - CapEX - NWC
What is the equation for the terminal value?
FCF10 * (1 + growth rate) / (WACC - growth rate)
How do you calculate WACC?
For equity use the Capital Asset Pricing Model
For debt use the (cost of debt * % debt) * (1 - tax rate)
What is Return on Assets?
= Net Income /Assets
Measures profitability for use of assets
What is Return on Equity?
= Net Income / Total Equity
How much money is generated through cash invested by shareholders
What kind of investment would have a negative Beta?
One that moves against the stock market as a whole. One asset that comes to mind is gold.
You have two companies with the same revenue, growth, risk, etc. but one is private and the other is public. Which company’s shares would be priced higher and why?
The public company since investors will pay a premium for its stocks liquidity and the transparency they get from regulations.
How do you value a private company?
The same way you value a public company, except you can’t use market cap and financials may be harder to find.
What is a collateralized debt obligation (CDO) ?
Broad asset class encompassing a variety of interest paying assets, are securatized and sold as bonds
May include mortgages, student loans, etc.
A CDO is a type of security that pools together a number of interest paying assets and pays “coupon payments” based on these assets future allotted cash flows.
Why do companies distribute dividends?
It is used as a signal of financial health, to encourage more investors to buy stocks in the equity capital markets.
What are the pros and cons of going public?
Pros: raising capital, cashing out for original investors, investor/employee compensation, don’t have to bother with debt payments
Cons: sharing future profits with stock holders, loss of confidentiality, loss of control, legal liabilities
What is preferred stock?
Preferred Stock is a hybrid of debt and equity. Pays a constant dividend to shareholders and may appreciate in value. In bankruptcy, they are paid out first.
What is EBITDA? How do you calculate it?
EBITDA is “Earnings Before Interest Tax Depreciation and Amortization”. It is frequently used to measure a company’s profitability and is sometimes used as a proxy for cash flows. You calculate it by taking EBIT (operating profit) from IS and add back D&A from CF statement.
What is goodwill?
Goodwill is the difference between the “book value” of a company and how much you would buy it for.
Walk me through the mathematical calculation of WACC…..
It is equal to the percent of equity in capital structure multiplied by the cost of equity
\+
Percentage of debt in capital structure multiplied by 1 - the tax rate multiplied by cost of debt
\+
Percentage of preferred stock in capital multiplied by the cost of stock
Walk me through how a $10 increase in depreciation would affect the financial statements of a company…..
Income statement: EBIT declines by $10, assuming a 30% tax rate Net Income would decrease by $7
Cashflow Statement: Net Income goes down by $7, but since depreciation is not a cash expense, $10 would be added back and overall the impact would be a $3 increase
Balance Sheet: PPE goes down $10 but cash up $3 (net down $7 on assets), Shareholders Equity decreases $7
Walk me through a debt issuance deal?
1) Meet with client and gather basic financial, industrial and customer information
2) Work with DCM/LBO to develop a debt model and decide the approximate leverage amount needed
3) Create investor memorandum describing all of the details
4) Go to potential debt investors and get commitments to finance the deal
What is common stock?
Represents a portion of ownership in a company, traded on exchanges such as the NYSE and NASDAQ, lowest on the totem pole in terms of repayment in default
What is the LBO Valuation method?
When you take the perspective of a private equity company looking to acquire a firm in a Leveraged Buyout. You estimate the target IRR and backtrack to find the price that works with foretasted financials
What is Beta?
Represents the volatility of risk asset against the total market
How can a company increase its share price?
1) Repurchase shares, thus reducing the amount of shares outstanding
2) Improve operations to increase profitability
3) Announce a new dividend policy
4) Cost Cutting
If a company’s stock has gone up 20% in the last 12 months, is it performing well?
Depends. If the market has gone up 10% then yes it is outperforming the market. If the market has gone up 30%, however, then it is under performing.
Is 15 a high P/E ratio?
Not a yes or no question, depends on which industry the company operates in, etc.
What does it mean to short a stock?
You are betting that the stock price will decrease. You borrow the stock from another investor, and then sell it, promising to return the stock to the lender at a later date.
When would a company collect cash from a customer and not show it as revenue?
When a company pays in advance for future delivery of a good (more than 12 months down the road). In this case, cash increases but so does “deferred revenue”, a liability.
What happens to Free Cash Flow if Net Working Capital increases?
If net working capital increases, that is a use of cash and free cash flow will decrease.
Why do we subtract cash from Enterprise Value?
Cash has already been accounted for, if we don’t subtract cash then it would be double counted.
How do you calculate the market cap of a public company?
Multiply number of shares outstanding by the share price.
How does a precedent transaction valuation work?
1) Find historical transactions similar to the one in question
2) Once found, look at the valuation methods and metrics. Calculate valuation multiple based on precedent sales price and apply to the multiple of the current company
(this is usually the highest valuation since buyers pay a premium for the company)
What are the two ways a credit default swap can be used?
1) Can be used as insurance for the buyer of a credit such as bond or loan to minimize risk (hedging)
2) Can be purchased as a speculation tool, if buyer believes credit will become distressed, the CDs for that company will be in higher demand and price will increase
What are covenants?
Covenants are requests a company must comply with according to legal documents in a loan/bond
What could a company do with excess cash on the balance sheet?
Holding too much cash is bad due to the opportunity cost of money
1) Reinvest into self to expand business
2) Bonuses to employees or dividends to shareholders
3) Invest in other opportunities with high NPV
Why might two companies with similar growth and profitability have different valuations?
This is likely due to some sort of competitive advantage not visible on financial statements, such as : unique intellectual property or strong management
All else equal, should the WACC of a company be higher for a $100 million dollar company or $100 billion dollar company?
Typically larger company is safer so would have a lower WACC
What is an IPO?
An IPO is an “Initial Public Offering”. It is the first sale of stock in a previously private company going public. The process is extremely complex so investment banks charge fees to assist companies in the process. The main purpose is to raise capital.
