Investment Banking

Technical Interview Workshop

Tuesday, January 19, 2010

Presented by:Justine Erickson

With contributions by Jessica Delfino, Mike Hudgin & Ekaterina Petrovitch

Introduction

Justine EricksonInvestment Banking Full-Time Analyst

RBC Capital Markets, Toronto

justine.erickson@mail.mcgill.ca

Agenda

• Interview Format

• Valuation

▫ DCF

▫ Public Comparables

▫ Precedent Transactions

• Sample Technical Questions

• The Infamous Accounting Question

• General Interviewing Tips

http://www.youtube.com/watch?v=3CsL1rcENH0

Deutsche Bank’s Interview Tips

Interview Format

• First Round

• 30-45 minutes

• Behavioural and lots of technical

• One to six interviewers

• Second Round

• 3-4 hours

• Expect even more technical (reactions under fatigue/pressure)

• One, two, or panel interviewers

How would you value a company?

Three General Ways to Value a Company:

1) Discounted Cash Flow

2) Public Comparables Analysis (Relative Valuation)

3) Precedent Transaction Multiples

For each method, interviewees should address:

• Basic overview (why this method is used)

• How it’s practically used (mechanics)

• Pros & cons of method

DCF – Overview

• DCF is the method of valuation that allows for the most flexibility (and possibly precision) in coming up with the intrinsic value of a firm▫ The DCF method that we use is FCFF (you might

know it as WACC method, but refrain from calling it this…)

• Mapped on many assumptions• Based on future expectations of a firm’s cash

flows (numerator), and the risks associated with those cash flows (denominator)

DCF – Basic Steps

• First determine WACC = D/V * Rd (1-T) + E/V * Re▫ Effect of capital structure Use target (optimal) D/E ratio Re , Beta CAPM Rd (1-T) discuss importance of tax shield

• Mechanics of FCFF ▫ FCFF = EBIT(1-T) – CAPEX + NCC +- Δ NWC Explain that CAPEX and NWC are all cash sources/uses that

don’t affect EBIT, therefore we must adjust.

• Analyze historical performance to come up with future set of assumptions (COGS, SG&A, R&D, “DEP”, “CAPEX”, “NWC” as a % sales)▫ Therefore, we need to use revenue as a driver, and

determine its growth from year to year during our explicit forecast period (5-10 yrs)

DCF – Basic Steps (cont’d)

• Determine FCFF’s each year using assumptions driven off of revenue

• Determine TV at last year of forecast period▫ 2 methods

Growing perpetuity ▫ Assumes constant growth rate (2-3%) – not really used

Terminal multiple▫ Assumes an exit multiple of an operating metric like

EBITDA or FCFF, to determine a value for the enterprise at that point in time

• Bring everything back to present value at WACC

DCF – Basic Steps (cont’d)

• Now we have the value of the enterprise (Enterprise Value = Net Debt + Equity + Minority Interest + Preferreds - Cash)

• In order to determine Equity Value, we must first subtract Net Debt & Minority Interest

• At this point we have Equity Value ▫ Divide by Shares Outstanding to obtain PPS

• Sensitivity analysis provides for flexibility in model▫ WACC / Growth Rates / Terminal Multiples

Too many assumptions

• The model is only as good as your assumptions

• Know sources of info used to develop assumptions

Allows for flexibility

• Firm can improve margins over time - DCF models are usually optimistic

• Industry outlook can change, and DCF model can reflect that

DCF – Pros & Cons

Public Market Comparables (Relative Valuation)

• Relative Valuation is a reality check to see how investors in the marketplace are valuing similar companies like the one in question

• Public Market Comparables are used to determine typical public market valuation with respect to certain operating metrics (EV/Sales, EV/EBITDA, P/E)

Relative Valuation – Basic Steps

• Determine the target company’s EPS, EBITDA, and Sales for current year and possibly forward year (using research analyst estimates)

• Determine the set of comparable companies (comp universe) and their trading multiples▫ Similar companies based on industry, size, business

model, risk, capital structure – anything you can control for

▫ Separate lists if company is a conglomerate• Multiply average industry multiple by current or

forward performance of target company to determine the relative value of the firm

Stock prices are determined by relative values Don’t have to make assumptions that are

necessary for DCFNot a gauge of intrinsic value

• Reflects the market’s current opinions on value –average could be skewed based on company-specific factors, especially in this economic environment

• Only values companies if they were valued the same way as their peers

Often difficult to find exact comparables • Can use sum-of-the-parts valuation for a diversified

corporation, which is a weighted-average of each division under specific industry multiples

Relative Valuation – Pros & Cons

Precedent Transactions – Overview

• Value of a company if it were to be taken over by another company (i.e. take-out value)

• Precedent transaction values should always yield higher values than relative valuation▫ Historical take-over premiums are 20-30%; much

higher recently. Be able to explain why!

• Not relevant if company is under certain scenarios (company is family-controlled and not looking to sell, etc.)

Precedent Transactions – Basic Steps

• Find historical takeovers within industry ▫ Again, look for similar transaction size, and most

recent first

• Try to cover at least one economic cycle in terms of precedent transactions, as some takeover premiums might reflect a takeover boom in an industry

• Multiply relevant multiples (P/E, EV/EBITDA, EV/Sales, etc.) by company’s figure to obtain firm’s value in event of a takeover

Often very relevant, especially for undervalued firms

Reflects how much the company would be worth in the eyes of its industry peers

Often used when firm is selling off a division

Only useful if firm will consider takeover

Precedent transaction values are often higher than intrinsic value (reflect over-payment in takeover transactions)

Precedent Transactions – Pros & Cons

Current Events

• Interest in finance will be tested during the interview

• Be prepared to discuss current events that you are following and able to respond to questions

• Case: Housing crisis in general

• Case: Kraft/Cadbury deal

• Case: Drastic commodity price fluctuations

• Case: Canwest CCAA filings

Sample Technical Questions

• If a company with a higher P/E acquires a company with a lower P/E, is this an accretive or dilutive merger?

• Why would an acquirer be willing to pay a premium to the current trading price?

• What method of valuation would result in the highest value? Why?

• What is minority interest? Why do we add it to the Enterprise Value formula?

• Can you walk me through a cash flow statement?

• How do you find a firm’s beta? How do you find a firm’s cost of debt?

• What are some different ways of calculating a firm’s cost of equity?

Sample Technical Questions Cont.

• What are some common valuation metrics?

• Why can’t you use EV/Earnings or Price/EBITDA as valuation metrics?

• Why do you subtract cash in the enterprise value formula?

• How would you calculate the return on equity for a private firm with no comparables?

• What is cheaper, debt or equity?

• If you own a start-up mining company in Canada and you require additional capital, would you rather finance your company with debt or equity? Why?

• What would have a greater impact on the value of a firm: a $1,000,000 rise in FCFF for the next five years, or a $500,000 rise in the terminal value FCFF?

Brainteasers

• Interviewers are not looking for you to answer the question immediately, it’s not a test of smarts

• Do not panic!

• Logically think through the question, interviewers are analyzing your capacity to think logically in stressful situations

• Think out loud, don’t sit in silence

• Ask questions if you’re confused but totally stumped (but make sure to listen to the answer well)

• Sometimes thinking backwards is the key to many brainteasers

• Don’t feel rushed, work through everything and they may help you along the way

• Speak confidently and clearly

• You don’t have to come up with an absolute correct answer, they are usually looking more for the way you approach the question

The Infamous Accounting Question …

If you are able to land interviews, particularly final rounds, you will be asked this question!

Question: A company makes a $100 purchase of equipment on Dec. 31. Half of this amount is paid for with cash, the other half is financed by debt. How does this impact the three financial statements this year and next year?

Key Points:

• Equipment Capital expenditure

• Order of financial statements 1) Income Statement 2) Cash Flow Statement 3) Balance Sheet (most difficult is to balance)

• Assume the company’s fiscal year end is Dec. 31

• This year and next year

• The numbers are not important, but use them when

learning the important underlying concepts

Income Statement:

• A purchase of equipment is considered a capital expenditure which does not impact earnings.

• Further, since the fiscal year end is Dec. 31, we are assuming no depreciation in the first year, and there is no impact to net income, thus no impact to the income statement.

• This holds true regardless of whether the capital expenditure is financed by debt or equity.

First Year

Cash Flow Statement:

• No change to net income so no change to cash flow from operations.

• $100 increase in capital expenditure: therefore a $100 use

of cash in cash flow from investing activities.

Cash Flow Statement Cont.:

• In our cash flow from financing section, we have an increase in debt of $50 (source of cash).

First Year

• Net effect is a use of cash of $50 (-$100 + $50)

Balance Sheet:

• Cash (asset) down by $50

• PP&E (asset) up by $100

• Debt (liability) up by $50

• Therefore, we balance!

Income Statement:

• Let’s assume straight-line depreciation over 5 years and a 40% tax rate.

• Let’s also assume a 10% interest rate on the debt and no debt amortization.

• Depreciation is an expense so operating income (EBIT)declines by $20 ($100/5 years).

Second Year

• $5 of interest expense (0.10 * $50).

• Net result is a $15 reduction to net income [$25 * (1 – 0.40)].

Cash Flow Statement:

• Net income down by $15 and depreciation up $20.

• No change to cash flow from investing or financing activities. (If we assumed some debt amortization, we would

have a use of cash in financing activities.)

Cash Flow Statement Cont.:

• Net effect is cash up $5.

Second Year

Balance Sheet:

• Cash (asset) up $5

• PP&E (asset) down $20

• Therefore left-side of Balance Sheet down $15

• Retained earnings (shareholders’ equity) down $15 (remember, net income decreased by $15?)

• And we balance!

If depreciation is non-cash, explain how this transaction caused cash to increase $5.

Final Part of the Question …

Answer:

Because of the depreciation and interest expenses, the company had to pay the government $5 less of taxes so it increased its cash position by $5 from what it would have been without the depreciation and interest expenses.

Another question you could be asked:

On Jan. 1 of Year 3 the equipment breaks and is deemed worthless. Assume the company pays back the loan immediately. What happens to all three statements?

General Interviewing Tips

• Take the time to think about the question before you answer it

• The last thing you want to do is go on a tangent or talk too much

• If you don’t know the answer right away, walk through your logical thinking process

• Always try to work out the problem. Don’t say I don’t know!!

• Don’t stress and keep your cool

• Be confident and comfortable

• Always have questions to ask them

• Don’t be cocky or pretend like you know everything about banking. Bankers, especially analysts, find this extremely aggravating and can see through it

• Don’t forget to e-mail them after your interview and thank them for their time

General Interviewing Tips (cont’d)

Tell me about yourself …

• Have a story (1-2 minutes)

• Logical flow

• Progression

• For everything you did, explain why (i.e. I chose business school because I’ve always been fascinated about what makes a good business)

• Be convincing that I-banking is what you want, and why

Super Day Dinners

• Everything is part of the interview

• DO NOT get drunk

• Try not to ask too many nerdy finance questions or talk about how bad the markets are – unless, of course, a banker asks you your opinion

• Expect out of the blue questions about the economy and investing

• Do not talk about things you don’t know anything about, try to learn from others, don’t be cocky

• Try to sneak your interests into conversations that aren’t always relevant in interviews (e.g., interest in art or different cultures)

• Goal: Try to come across as an interesting and ambitious person who can also have some fun and be enjoyable to work with

• One slight mess up can definitely cost you your offer

• Judgment and social skills are extremely important parts of your job as an investment banking analyst, and the Super Day dinner is a quick way to evaluate these

General Interviewing Tips (cont’d)

Why I-banking?

• Many good answers• Suggestions

• Being able to learn a boatload in a short amount of time

• Being surrounded by intelligent people willing to teach

• Interest in financial markets

• Like to work on projects and see rewarding results (even see it in the paper…)

• Intense environment, fast-paced, pressure, multi-tasking

• Anything else that suits you …

Questions to Ask Them

• What made you choose [insert firm’s name]?

• Have you seen the current economic turmoil/credit crisis affecting your everyday work? If so, how?

• In what industries does your office see the most dealflow?

• As a summer analyst will I be placed in one industry group or will I be a generalist?

• How would you describe the culture of your office?

• What, in your opinion, is the most important aspect or quality that a summer analyst should possess and display?

• Finally, ask questions pertaining to your interviewer specifically to show you’ve been listening. For example, “What made you initially switch to private equity and then what drew you back to investment banking?” or, “How did you find the New York/London office compares to the Toronto office?”

Resources

• Career Services website: Vault Guide to Finance Interviews

▫ http://www.mcgill.ca/management/career

• Damodaran online: more material on valuation

▫ http://pages.stern.nyu.edu/~adamodar/

• News: Wall Street Journal, Bloomberg, Financial Times, etc.