Breaking Into Wall Street – Investment Banking Interview Guide

Sample Technical Interview #1 – Basic

Narrator: In this lesson, we’ll conduct a “basic” technical interview with an investment banking
hopeful.

This one is labeled “basic” because these are the technical questions you’ll be expected to know
no matter what your background is – basic accounting, valuation, and modeling. The technical
questions you receive may be significantly more difficult than the ones here, especially if you
have a finance background – but it’s still good to review the basics.

As with the other sample interviews in this course, this one is good but not perfect – the
interviewee makes some mistakes throughout, and could refine many of his answers. For the
full analysis and commentary, you can review the video that accompanies this lesson.

Now, let’s jump into the interview.

Interviewer: Ok, great, Jamie, nice to meet you, glad to have you here today. I have your
resume in front of me, but I haven’t had a chance to go through it in detail yet – maybe you can
just get started by briefly walking me through your resume and some of your previous
experience?

Interviewee: Sure. I was born and grew up in a small town in Colorado. And growing up, I
was always surrounded by my dad’s work, since he was an attorney at the largest law firm in
our region.

And my parents wanted me to be either the stereotypical doctor or lawyer, so I had that
“professional mindset” from a very early age.

Since Colorado is a small state and there’s not much diversity, I decided to leave and attend
University of Michigan to gain broader exposure and learn more about the world.

While there, I started off thinking I was going to do either law or medicine – but midway
through my sophomore year, I spoke with some friends in the Finance Club there and became
more interested in business.

I liked how much faster-paced it was and how it would allow me to actually do real work
without spending years more of my life in school first – I decided to change the focus of my
studies and also take some Economics and Finance courses, and learn as much as I could about
the field.

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I spoke with alumni and other friends and did some networking to get my first business
internship, doing marketing at a local Internet company started by a few Michigan alumni.

That was definitely a step in the right direction, and I liked the subject more than what I had
been studying – however, I realized that I was fascinated by that more than by just an
individual company and wanted to learn about the markets.

I continued networking, and worked at Morgan Stanley’s Private Wealth Management division
this past summer.

That definitely moved me in the right direction, and allowed me to analyze markets and
individual investments and then match them with appropriate clients. I liked the quantitative
aspect and working on more long-term projects, but during the course of that internship, I
realized that it was the transactions that interested me more than just the day-to-day market
happenings.

I liked working in the markets, but what I wanted was to work more with the movers and
shakers rather than just high net-worth individuals.

And that led me to my interest in investment banking and explains why I’m here today – for the
chance to apply my knowledge and skills to what I’m most interested in.

Interviewer: Ok, great. And yeah, I think that’s a fairly common story – a lot of bankers have
grown up with professional parents, or think about law or medicine first, before deciding on
finance or whatever they do instead.

And since you’ve already had some experience in the field, I figured we could get started with a
few technical questions, starting with just a few topics and questions on Accounting.

Interviewee: Sure.

Interviewer: Ok, so maybe you can start by just walking me through the 3 major financial
statements.

Interviewee: Ok. The 3 financial statements are the Income Statement, Balance Sheet and Cash
Flow Statement. The Income Statement starts off with Revenue at the top and then lists the
company’s expenses, eventually going down to the bottom line – the Net Income line.

The Balance Sheet lists the company’s Assets and its Liabilities & Shareholders’ Equity, which
must always balance between the two sides. It’s showing the company’s resources and where
they’ve obtained them from.

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Finally, the Cash Flow Statement starts out with Net Income, adjusts for non-cash expenses, as
well as changes in Working Capital and also for any Cash Flow from Investments and
Financing, to get to the Net Change in Cash at the bottom.

The way everything links together is that the Net Income flows into Shareholders’ Equity on the
Balance Sheet, the changes in Working Capital on the Balance Sheet show up on the Cash Flow
Statement, and the Net Change in cash from the Cash Flow Statement shows up as the new cash
number on the Balance Sheet.

Were you looking for any more detail here?

Interviewer: No, that’s exactly what I was looking for – I think that’s good enough for now. So
you described pretty well the 3 statements and how they’re linked – but let’s just take a second
here and go through a hypothetical scenario. Let’s say that you’re stranded on a desert island
and you only have access to 2 of the company’s financial statements, and you want to get a
picture of the business as a whole. Which 2 statements do you think you would pick?

Interviewee: I’m not 100% certain, but I think you’d want to look at the Income Statement and
the Balance Sheet, because they tell you how much the company is earning and what it’s using
to earn that money. You can also get to a lot of the items on the Cash Flow Statement from
those 2.

Interviewer: Ok, great, that’s right. You’d definitely pick the Income Statement and the Balance
Sheet since you can effectively create the Cash Flow Statement from those, assuming of course
that you actually have a “Previous” and “Current” Balance Sheet. With that said, now let’s go
into the specific statements – so maybe you could start with the Income Statement and just walk
me through what happens when Depreciation goes up by $10?

Interviewee: Sure. First, the Cost of Goods Sold on the Income Statement would go down by
$10, so Gross Profit, Operating Income and Pre-Tax Income would also decrease by $10. If you
assume a tax rate of 40%, Net Income would then decline by $6. Next, on the Cash Flow
Statement, Net Income is down by $6 and Depreciation would be up by $10, so the Net Change
in Cash at the bottom is an increase by $4.

Finally, on the Balance Sheet, the Cash Balance would go up by $4, the Property & Equipment
would go down by $10 because of the Depreciation. Overall, Assets fall by $6. On the other
side, Shareholders’ Equity would also fall by $6 because Net Income is $6 lower, so the Balance
Sheet still balances.

Interviewer: Ok, good. Now let’s look at a slightly different scenario. So maybe, again, we can
just go through the 3 statements and you can tell me what happens when the company issues
$10 of additional debt – so just forget about Depreciation and whatever that does for now, and
let’s just isolate this and look at what happens when they issue $10 worth of additional debt.

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Interviewee: Yeah. First, you would have to take into account the Interest Expense – if we
assume a 10% interest rate on that money, then the Pre-Tax Income would fall by $1 on the
Income Statement…

Interviewer: Ok, let me just stop you right there – it’s important to note here that this is
immediately after the debt has been issued. So there would be an Interest Expense maybe if we
waited awhile –waited for a year or two – but we’re going to assume this is immediately after
the debt has been issued and nothing else has happened yet. If that’s the case, would there be
any changes to the Income Statement?

Interviewee: Um, in that case, there would be no changes to the Income Statement if it’s right
after the debt has been issued. On the Cash Flow Statement, there would be $10 of debt that
shows up under Cash Flow from Financing and the Net Change in Cash would be up by $10;
then the Balance Sheet would balance since Cash would be up $10 on the Assets side and Debt
would also be up by $10 on the Liabilities side.

Interviewer: Ok, good – so the Balance Sheet Liabilities & Shareholders’ Equity side would go
up by $10, and then the Cash on the Assets side would also rise by $10 to balance it out. So you
have a pretty good understanding of Accounting topics – so maybe let’s move onto a few other
topics.

So let’s just move into Valuation here – and to start things off, maybe you could just tell me
what the 3 major Valuation methodologies are.

Interviewee: Sure. The 3 major methods are Public Company Comparables, Precedent
Transactions and DCF, or Discounted Cash Flow analysis.

Interviewer: Good. I know it’s always difficult to generalize, but out of those 3 methodologies,
which one do you think would produce the highest valuation for a company?

Interviewee: Well, usually Precedent Transactions will give you a higher value than
Comparable Companies because an acquirer usually has to pay a premium to acquire a
company. So any Purchase Price for the company would reflect that premium. DCF would
tend to give you the highest valuation of all, since it depends on assumptions you make far in
the future and it’s hard to predict what will happen in 5 or 10 years – or at least the market
won’t give you as much credit as a DCF model typically does.

Interviewer: Ok, good, so I agree with you that the Precedent Transactions will usually give
you a higher valuation than Comparable Companies, because of the control premium, as you
mentioned. But going back to what you said about the DCF – will that always give you the
highest valuation? If it’s so dependent on assumptions far into the future, couldn’t it also give
us the lowest valuation?

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Interviewee: That’s true – so I guess a DCF is the most variable of the methodologies, but it
could actually be the highest or lowest depending on what you assume.

Interviewer: Good. And yeah, that’s true – usually the DCF does tend to give higher
valuations, but it’s not always the highest because it is so dependent on assumptions, as you
said, and depending on what you assume it really could go either way.

But generally we can say that Precedent Transactions tend to give higher valuations than
Comparable Companies – again, not always true in all cases, but it’s a generalization that
usually holds. Now, you mentioned those 3 methodologies when we were starting out – the
Comparable Companies, Precedent Transactions, and the DCF – when you’re valuing a
company, are there any cases where you would not use one of those methodologies?

Interviewee: Sometimes you don’t have good Precedent Transactions, or sometimes there
might not be any companies that are similar to whatever you’re trying to value, so you might
not be able to use either of those. Also, if a company isn’t profitable or doesn’t have predictable
cash flows, you might not use a DCF.

Interviewer: Good – that’s exactly right. Whenever you have unstable cash flows, it’s some
kind of high-growth company, some kind of Internet or bio-tech startup where you can’t really
predict the cash flows too far in advance, then you wouldn’t really use a DCF.

With that said, let’s move onto a few other topics now – related to Valuation is this concept of
the Equity Value of a company and the Enterprise Value of a company – and on that note,
there’s also this concept of Basic Shares Outstanding and Fully Diluted Shares Outstanding, and
then Basic Equity Value and Fully Diluted Equity Value. So are you familiar with this Fully
Diluted Equity Value concept?

Interviewee: Yeah, it’s when you take into account the options and warrants that a company
has and you include those in calculating the Market Cap rather than just using the Market Cap
on Yahoo! or Google Finance.

Interviewer: Good – and yeah, you use the options, the warrants, the convertibles and maybe
even other securities depending on what you’re looking at to calculate a company’s true value.

So maybe we can just walk through a simple example of how you calculate the Fully Diluted
Equity Value – just a very simple case – let’s say that we have 100 shares at a share price of $10,
and we also have 10 options outstanding and they each have an exercise price of $5. How
would you calculate the Fully Diluted Equity Value in this case?

Interviewee: Ok, could I take a second to write down this information?

Interviewer: Sure, feel free to use whatever paper or whatever else you need to make the
calculations.
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Interviewee: Ok, so if you have 10 options with an exercise price of $5 each, and you can
exercise each one. So you get 10 new shares and now have 110 shares outstanding rather than
100. But to exercise each one, you also have to pay the company $5 for each new share, so they
have $50 in additional cash, which they can use to buy back 5 of the new shares. So you end up
with 105 shares total.

Interviewer: Good, I think you have the right idea – so in this scenario we would get to 105
diluted shares outstanding, and the Equity Value – which is what we were trying to get to –
would be $1,050, or 105 times $10.

Also on this topic, I mentioned how the Fully Diluted Equity Value is a better measure of what
a company is worth – but that’s not really the whole story when we’re talking about valuation
and thinking about companies. In a lot of cases – actually in most cases – we look at the
Enterprise Value when thinking about what it costs to really acquire a company. So could you
describe how to calculate the Enterprise Value?

Interviewee: Sure. The formula for Enterprise Value is Equity Value, minus the Cash, plus the
Debt and Preferred Stock.

Interviewer: Ok – but what if, for example, the company has a Minority Interest in another
company, or if it has some kind of other investment in another entity?

Interviewee: To be honest, I’m not sure, but I think you would add it to the Enterprise Value
because it costs something to acquire the investment from the company. So the formula should
also add Minority Interest to the Equity Value.

Interviewer: Right – the Minority Interest really means that the company owns over 50% of
another company, but it doesn’t yet own the whole thing. And to do an apples-to-apples
comparison, we have to add the percentage of the company that they don’t own to their
Enterprise Value, because the company’s financials have been figured into the company we’re
valuing already – so again, it’s just in the interest of really doing an apples-to-apples
comparison.

And now, let’s shift our focus a little bit again and just move onto some basic financial modeling
– I realize you haven’t done investment before, but you did work in private wealth
management, and I assume from some of your classes and such, you might know a little bit
about this.

So maybe we could just start by walking through a basic Discounted Cash Flow model – I don’t
want a lot of detail here, just the basics – just give me a high-level overview of what you do.

Interviewee: Ok. The basics of a DCF analysis – you’re valuing the company’s Cash Flow in
each year, and then adding the Terminal Value – what it’s worth after several years – to the
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value of those Cash Flows. And each of those Cash Flows is discounted depending on how far
ahead it is into the future.

First, you would project the company’s Income Statement out several years, and go from
Revenue at the top to Free Cash Flow at the bottom. After you have Free Cash Flow in each
year, you discount each value by the Weighted Average Cost of Capital, and then sum up all
the values.

As for the Terminal Value that you add onto those Discounted Cash Flows, you either assume a
multiple and apply it to the company’s EBITDA or Free Cash Flow, or you assume it grows at a
certain rate for each year into the future.

Then, you discount that by the Discount Rate, or WACC, and add it back with the value of
those Free Cash Flows, and that’s the company’s valuation according to DCF.

Interviewer: Ok, good. And so when you’re going through and calculating the Free Cash Flow
in each year, which you mentioned you have to do as part of the analysis, how do you move
from the Revenue line at the top of the Income Statement down to the Free Cash Flow line?

Interviewee: You start with Revenue, and then subtract the company’s expenses, such as Cost
of Goods Sold and Sales & Marketing and General & Administrative and move down to Gross
Profit and then Operating Income.

Then, without subtracting the Interest Expense, you use the tax rate to figure out how much tax
you owe, and subtract that from Operating Income – then you add back Depreciation, subtract
the Change in Working Capital and subtract Capital Expenditures to get to Free Cash Flow.

Interviewer: Ok, good, and that’s exactly how you would get to Free Cash Flow in most cases in
a DCF. And just another topic I wanted to go over briefly with the time remaining – and again, I
realize you haven’t done banking before, but just figured you might know something about
this, either from your finance classes or maybe from elsewhere or from studying you’ve done
on your own, but maybe you could just again take a few minutes and just walk me through the
basics of a merger model, sometimes called an accretion/dilution model.

And again, I don’t want a ton of detail on everything – I just want the basics, just a very high-
level overview of what you do.

Interviewee: Sure. The first step is to assume how much it costs to acquire the company, and
then decide if you’re paying in cash, stock or debt.

Then, you project out the buyer and the seller’s Income Statements and go from Revenue to Net
Income.

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Then, you add together the two Income Statements. If cash was used, you subtract the
Foregone Interest on Cash used to finance the acquisition in the Pretax Income line, and if debt
was used, you subtract the Interest Paid on Debt in Pretax Income. If new shares were issued,
you adjust the share count.

Finally, you apply the buyer’s tax rate to Pretax Income to get to the Net Income of the
combined company, and divide by the new Shares to get their Earnings Per Share and see if it
was accretive.

Interviewer: Right, I think you have the right idea there. And you mentioned how there were
several different ways to buy a company – in most cases, cash, stock, or debt. Is there any rule of
thumb for telling whether or not an acquisition will be accretive or dilutive – whether it will
add to or subtract from the buyer’s Earnings Per Share?

Interviewee: Yeah, usually if the buyer’s P/E ratio is higher than the seller’s, then the deal will
be accretive, and vice versa – if it’s less, then it will be dilutive.

Interviewer: Ok. And I agree with you that the rule you mentioned can be a good guide –
mainly if it’s an all-stock deal, where that rule almost always applies. But let’s look at a slightly
different scenario – it’s easy to see why it only really works 100% of the time if it’s an all-stock
deal – because P/E basically reflects exactly what you’re paying for each penny of earnings.

But if cash or debt are involved, it doesn’t always work – so is there any kind of rule of thumb
that we could use if, let’s say, we’re acquiring a company using cash or debt instead of stock?

Interviewee: I’m not really sure, but I think you would have to see how much the lost interest
on Cash or interest on Debt affects the Pretax Income and see what happens based on that.

Interviewer: Yeah, I think – as far as I know – there isn’t a hard-and-fast rule that you can
always use in those cases. But yeah, in general, you’d have to look at the lost cash or additional
debt affect your interest expense and then see how much the seller is contributing, and see
which is greater – but basically there’s no quick and easy way to do it. You actually have to look
at the numbers in most cases.

Ok, and just with the time remaining we have here – I realize you have a bunch of other
interviews ahead of you today – but just with the time left here, did you have any questions you
wanted to ask me?

Interviewee: Yeah, can you talk a little bit about your experiences here and how they compare
to what you would find at other large banks?

Interviewer: Sure. I think one of the really unique parts of our firm is that it – and it sounds
cliché, but I think it is true – it does feel like a “boutique within a bulge bracket.” Over recent
history, with many of our competitors gone now, we have pretty good deal flow and we’re
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always pretty busy because deals are still happening but there aren’t quite as many banks
around anymore.

Even though we work on some pretty large transactions – sizable deals that are written about in
the mainstream press and everything – peoples’ doors are always open, people are pretty
friendly, and I think even as an Analyst you can get a lot of personal attention from the senior
people, which is nice.

They’re even willing to help you out with recruiting after you finish up here, and they’ve
definitely helped people with recommendations for other jobs, for business school, and really
for whatever you’re looking for – and I think that’s really what sets us apart. Because even
though it’s large, we’re a lot more personal than other firms and you can learn a lot from
everyone around you here.

Well, again, I don’t want to delay you from heading over to your other interviews and speaking
with some of the other people here today – so it was great meeting you, and I wish you the best
of luck with everything else you have lined up today. We should probably be getting back to
you within a week or so on your status and the next steps in the process – so in the meantime,
you have my contact information, so just let me know if you have any questions.

Interviewee: Thanks, and hope to see you in the future.

Interviewer: Ok, take care.

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