The six most common investment banking interview questions and how to answer them
Beecher Tuttle | E-Financial Careers
For recent graduates, investment banking interviews are built on two main structures: personal behavioral questions and technical queries. As we’re told, the latter tend to be rather formulaic. There are only so many technical questions an interviewer can ask. Still, the questions can be answered in many different ways. Like case studies, it’s often more about how you explain your logic.
Below are six questions commonly asked in investment banking interviews, along with potential answers put together by a business school graduate now working on Wall Street. How did they do? Let us know in the comments.
Define Beta for a layman
Beta tells you how much the price of a given security moves relative to movements in the overall market.
A Beta of 1 means that if the market moves, the stock moves in unison with the market.
A Beta < 1 means that if the market moves a certain amount, the stock will move less than that amount
A Beta >1 means that if the market moves a certain amount, the stock will move more than that amount.
What is CAPM?
CAPM is the Capital Asset Pricing Model, and it is a model designed to find the expected return on an investment and therefore the appropriate discount rate for a company’s cash flows. It is a linear model with one independent variable: beta.
CAPM divides the risk of holding risky assets into systemic and specific risks. To the extent that any asset is affected by general market moves, that asset entails systematic risk. Specific risk is the risk which is unique to an individual asset. It represents the component of an asset’s volatility which is uncorrelated with general market moves. According to CAPM, the marketplace compensates investors for taking systematic risk, but not specific risk.
CAPM considers a simplified world in which there are no taxes or transaction costs. All investors have identical investment horizons. All investors have identical perceptions regarding the expected returns, volatilities and correlations of available risky investments.
Formula: Ri = Rf + Beta * (MRP)
Rf = risk‐free rate (use 10‐year Treasury)
MRP = Market Risk Premium (Rm – Rf)
Rm = Expected Return of Market
Of the three main valuation methods (DCF, public comparables and transaction comparables), rank them in terms of which gives you the highest price? Which one yields the highest valuation?
Simple answer: It depends. Depends on discount rate in DCF model, depends on the comparable companies used, depends on whether the market is hot/cold and the companies are overvalued/undervalued for no good reason.
Generally, however, transaction comps would give the highest valuation, since a transaction value would include a premium for shareholders over the actual value.
The second highest valuation would probably be the DCF, since there are a lot more assumptions that are involved (growth rate, discount rate, terminal value, tax rates, etc.), but it can also be the most accurate depending on how good the assumptions are.
Trading comps offer the least wiggle room and will solely depend on the choice of companies and how the market treats them.
If you had to pick one statement to look at (balance sheet, cash flow, income statement), which one would it be and why?
No right answer. Can go with whichever one you like. Each has its advantages. Income statement shows the profitability of a company, trends in sales/expenses margins, etc.; balance sheet is a great way to see what items make up the company’s assets and whom the company needs to pay back for those assets. Personally, I would go with cash flow statement. At the end of the day, cash is king. A company that has positive income but very little cash is in deep trouble.
Cash flows are used for DCF models, not net income. The cash flow statement allows observing important performance metrics from both income statements and balance sheets such as net income, depreciation, sources and uses of funds, changes in assets and liabilities.
What is the difference between commercial and investment banking?
There are many definitions, but these are some of the broader ideas that differentiate the two:
Commercial bank: accepts deposits from customers and makes consumer and commercial loans using these deposits. The vast majority of loans made by commercial banks are held as assets on the bank’s balance sheet.
Investment bank: acts as an intermediary between companies and investors. Does not accept deposits, but rather sells investments, advises on M&A, etc…loans and debt/equity issues originated by the bank are not typically held by the bank, but rather sold to third parties on the buy side through their sales and trading arms.
What is accretion and dilution? — Give an example
Accretion is asset growth through addition or expansion. Accretion can occur through a company’s internal development or by way of mergers and acquisitions.
Dilution is a reduction in earnings per share of common stock that occurs through the issuance of additional shares or the conversion of convertible securities. Adding to the number of shares outstanding reduces the value of holdings of existing shareholders.
An acquisition is accretive when the combined (pro forma) EPS is greater than the acquirer’s standalone EPS. For example, suppose analysts expect Procter & Gamble’s EPS to be $3.05 next year. You are a banker charged with the task of modeling the impact to Procter & Gamble’s EPS if they were to acquire Colgate-Palmolive (this is purely hypothetical by the way). So you build your model and determine that the pro form EPS next year would actually be $3.10 — $0.05 higher than had the acquisition not taken place. In other words, the deal would be $0.05 accretive next year. An acquisition is dilutive if the opposite is determined: that pro forma EPS would be lower than $3.05. A deal is considered breakeven when there is virtually no impact on EPS.
Accretion: When pro forma EPS > Acquirer’s EPS
Dilution: When pro forma EPS < Acquirer’s EPS
Breakeven: No impact on Acquirer’s EPS