Investment Banking Interview Questions

The balance sheet is a snapshot of a point in time.  On the top half you have the company's Assets and on the bottom half its Liabilities and Shareholders' Equity (or Net Worth). The assets and liabilities are typically listed in order of liquidity and separated between current and non-current.

The income statement covers a period of time, such as a quarter or year.  It illustrates the profitability of the company from an accounting (accrual and matching) perspective.  It starts with the revenue line and after deducting expenses derives net income.

The cash flow statement has three sections: cash from operations, cash used in investing, and cash from financing.  It can be calculated using the direct approach or the reconciliation approach.  It “undoes” all of the accounting principles and shows the cash flows of the business.

There are three common valuation methods used in IB:

1) The multiples approach (also called “comps”), in which you multiply the earnings of a company by the P/E ratio of the industry in which it competes (and other ratios).

2) Transactions approach (also called “precedents”), where you compare the company to other companies that have recently sold/been acquired in that industry.

3) The Discounted Cash Flow approach, in which you discount the values of future cash flows back to the present.

[Note: Value = Cash Flow / WACC].

$2,000, because: $200 / 10% = $2,000 (i.e. 10x)

There are many reasons to issue debt instead of equity:

1. It is a less risky and cheaper source of financing compared to issuing equity; 2. If the company has taxable income, issuing debt provides the benefit of tax shields;

3. If the firm has immediately steady cash flows and is able to make its interest payments;

4. Higher financial leverage helps maximize the return on invested capital;

5. when issuing debt yields a lower weighted cost of capital (WACC) than issuing equity.

''To tie the statements together, Net Income from the Income Statement flows into Shareholders’ Equity on the Balance Sheet, and into the top line of the Cash Flow Statement.

Changes to Balance Sheet items appear as working capital changes on the Cash Flow Statement, and investing and financing activities affect Balance Sheet items such as PP&E, Debt, and Shareholders’ Equity. The Cash and Shareholders’ Equity items on the Balance Sheet act as “plugs,” with Cash flowing in from the final line on the Cash Flow Statement.”

Income Statement: Operating Income would decline by $10 and assuming a 40% tax rate, Net Income would go down by $6. 

Cash Flow Statement: The Net Income at the top goes down by $6, but the $10 Depreciation is a non-cash expense that gets added back, so overall Cash Flow from Operations goes up by $4. There are no changes elsewhere, so the overall Net Change in Cash goes up by $4.

Balance Sheet: Plants, Property & Equipment goes down by $10 on the Assets side because of the Depreciation, and Cash is up by $4 from the changes on the Cash Flow Statement.

Overall, Assets are down by $6. Since Net Income fell by $6 as well, Shareholders’ Equity on the Liabilities & Shareholders’ Equity side is down by $6, and both sides of the Balance Sheet balance.

Note: With this type of question I always recommend going in the order: 

1. Income Statement 2. Cash Flow Statement 3. Balance Sheet

This is so you can check yourself at the end and make sure the Balance Sheet balances.

Remember that an Asset going up decreases your Cash Flow, whereas a Liability going up increases your Cash Flow. 

At the start of “Year 1,” before anything else has happened, there would be no changes on Apple’s Income Statement (yet).

On the Cash Flow Statement, the additional investment in factories would show up under Cash Flow from Investing as a net reduction in Cash Flow (so Cash Flow is down by $100 so far). And the additional $100 worth of debt raised would show up as an addition to Cash Flow, canceling out the investment activity. So the cash number stays the same.

On the Balance Sheet, there is now an additional $100 worth of factories in the Plants, Property & Equipment line, so PP&E is up by $100 and Assets is therefore up by $100. On the other side, debt is up by $100 as well and so both sides balance.

Working Capital = Current Assets – Current Liabilities

If it’s positive, it means a company can pay off its short-term liabilities with its short-term assets. It is often presented as a financial metric and its magnitude and sign (negative or positive) tell you whether or not the company is “sound.” 

Bankers look at Operating Working Capital more commonly in models, and that is defined as (Current Assets – Cash & Cash Equivalents) – (Current Liabilities – Debt).

The point of Operating Working Capital is to exclude items that relate to a company’s financing activities – cash and debt – from the calculation.

Accounts receivable has not yet been collected in cash from customers, whereas deferred revenue has been. Accounts receivable represents how much revenue the company is waiting on, whereas deferred revenue represents how much it has already collected in cash but is waiting to record as revenue.

Several possibilities:

1. The company is spending too much on Capital Expenditures – these are not reflected at all in EBITDA, but it could still be cash-flow negative.

2. The company has high interest expense and is no longer able to afford its debt.

3. The company’s debt all matures on one date and it is unable to refinance it due to a “credit crunch” – and it runs out of cash completely when paying back the debt.

4. It has significant one-time charges (from litigation, for example) and those are high enough to bankrupt the company.

First, note that this question does not apply to you if you’re outside the US as IFRS does not permit the use of LIFO. But you may want to read this anyway because it’s good to know in case you ever work with US-based companies.

LIFO stands for “Last-In, First-Out” and FIFO stands for “First-In, First-Out” – they are 2 different ways of recording the value of inventory and the Cost of Goods Sold (COGS).

With LIFO, you use the value of the most recent inventory additions for COGS, but with FIFO you use the value of the oldest inventory additions for COGS.

Here’s an example: let’s say your starting inventory balance is $100 (10 units valued at $10 each). You add 10 units each quarter for $12 each in Q1, $15 each in Q2, $17 each in Q3, and $20 each in Q4, so that the total is $120 in Q1, $150 in Q2, $170 in Q3, and $200 in Q4.

You sell 40 of these units throughout the year for $30 each. In both LIFO and FIFO, you record 40 * $30 or $1,200 for the annual revenue.

The difference is that in LIFO, you would use the 40 most recent inventory purchase values – $120 + $150 + $170 + $200 – for the Cost of Goods Sold, whereas in FIFO you would use the 40 oldest inventory values – $100 + $120 + $150 + $170 – for COGS.

As a result, the LIFO COGS would be $640 and FIFO COGS would be $540, so LIFO would also have lower Pre-Tax Income and Net Income. The ending inventory value would be $100 higher under FIFO and $100 lower under FIFO.

In general if inventory is getting more expensive to purchase, LIFO will produce higher values for COGS and lower ending inventory values and vice versa if inventory is getting cheaper to purchase.

They arise because of temporary differences between what a company can deduct for cash tax purposes vs. what they can deduct for book tax purposes.

Deferred Tax Liabilities arise when you have a tax expense on the Income Statement but haven’t actually paid that tax in cold, hard cash yet; Deferred Tax Assets arise when you pay taxes in cash but haven’t expensed them on the Income Statement yet.

They’re most common with asset write-ups and write-downs in M&A deals – an asset write-up will produce a deferred tax liability while a write-down will produce a deferred tax asset (see the Merger Model section for more on this).

The “quick and dirty” way to do this: reduce the Taxable Income by the portion of the NOLs that you can use each year, apply the same tax rate, and then subtract that new Tax number from your old Pretax Income number (which should stay the same).

The way you should do this: create a book vs. cash tax schedule where you calculate the Taxable Income based on NOLs, and then look at what you would pay in taxes without the NOLs. Then you book the difference as an increase to the Deferred Tax Liability on the Balance Sheet.

This method reflects the fact that you’re saving on cash flow – since the DTL, a liability, is rising – but correctly separates the NOL impact into book vs. cash taxes.

Operating leases are used for short-term leasing of equipment and property, and do not involve ownership of anything. Operating lease expenses show up as operating expenses on the Income Statement.

Capital leases are used for longer-term items and give the lessee ownership rights; they depreciate and incur interest payments, and are counted as debt.

A lease is a capital lease if any one of the following 4 conditions is true:

1. If there’s a transfer of ownership at the end of the term.

2. If there’s an option to purchase the asset at a bargain price at the end of the term.

3. If the term of the lease is greater than 75% of the useful life of the asset.

4. If the present value of the lease payments is greater than 90% of the asset’s fair market value.

Enterprise Value represents the value of the company that is attributable to all investors; Equity Value only represents the portion available to shareholders (equity investors). You look at both because Equity Value is the number the public-at-large sees, while Enterprise Value represents its true value.

EV = Equity Value + Debt + Preferred Stock + Noncontrolling Interest – Cash

This formula does not tell the whole story and can get more complex – see the Advanced Questions. Most of the time you can get away with stating this formula in an interview, though.

“Noncontrolling Interest” was formerly known as Minority Interest and some bankers still call it that.

Its basic equity value is $1,000 (100 * $10 = $1,000). To calculate the dilutive effect of the options, first you note that the options are all “in-the-money” – their exercise price is less than the current share price.

When these options are exercised, there will be 10 new shares created – so the share count is now 110 rather than 100.

However, that doesn’t tell the whole story. In order to exercise the options, we had to “pay” the company $5 for each option (the exercise price).

As a result, it now has $50 in additional cash, which it now uses to buy back 5 of the new shares we created.

So the fully diluted share count is 105, and the fully diluted equity value is $1,050.

The “official” reason: Cash is subtracted because it’s considered a non-operating asset and because Equity Value implicitly accounts for it.

The way I think about it: In an acquisition, the buyer would “get” the cash of the seller, so it effectively pays less for the company based on how large its cash balance is. Remember, Enterprise Value tells us how much you’d really have to “pay” to acquire another company

It’s not always accurate because technically you should be subtracting only excess cash – the amount of cash a company has above the minimum cash it requires to operate.

Yes – it’s too simple. There are lots of other things you need to add into the formula with real companies:

• 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.

So a more “correct” formula would be Enterprise Value = Equity Value – Cash + Debt + Preferred Stock + Noncontrolling Interest – NOLs – LT and Equity Investments + Capital Leases + Unfunded Pension Obligations…

In interviews, usually you can get away with saying “Enterprise Value = Equity Value – Cash + Debt + Preferred Stock + Noncontrolling Interest” 

I mention this here because in more advanced interviews you might get questions on this topic.

Technically, you should use market value for everything. In practice, however, you usually use market value only for the Equity Value portion, because it’s almost impossible to establish market values for the rest of the items in the formula – so you just take the numbers from the company’s Balance Sheet.

Trick question – there is no ranking that always holds. In general, Precedent Transactions will be higher than Comparable Companies due to the Control Premium built into acquisitions.

Beyond that, a DCF could go either way and it’s best to say that it’s more variable than other methodologies. Often it produces the highest value, but it can produce the lowest value as well depending on your assumptions.

You do not use a DCF if the company has unstable or unpredictable cash flows (tech or bio-tech startup) or when debt and working capital serve a fundamentally different role. For example, banks and financial institutions do not re-invest debt and working capital is a huge part of their Balance Sheets – so you wouldn’t use a DCF for such companies.

EBITDA is available to all investors in the company – rather than just equity holders. Similarly, Enterprise Value is also available to all shareholders so it makes sense to pair them together.

Equity Value / EBITDA, however, is comparing apples to oranges because Equity Value does not reflect the company’s entire capital structure – only the part available to equity investors.

The 3 main ways to select companies and transactions:

1. Industry classification

2. Financial criteria (Revenue, EBITDA, etc.)

3. Geography

For Precedent Transactions, you often limit the set based on date and only look at transactions within the past 1-2 years.

The most important factor is industry – that is always used to screen for companies/transactions, and the rest may or may not be used depending on how specific you want to be.

Here are a few examples:

Comparable Company Screen: Oil & gas producers with market caps over $5 billion

Comparable Company Screen: Digital media companies with over $100 million in revenue

Precedent Transaction Screen: Airline M&A transactions over the past 2 years involving sellers with over $1 billion in revenue

Warren Buffett once famously said, "Does management think the tooth fairy pays for capital expenditures?” 

He dislikes EBITDA because it hides the Capital Expenditures companies make and disguises how much cash they are actually using to finance their operations.

In some industries there is also a large gap between EBIT and EBITDA – anything that is very capital-intensive, for example, will show a big disparity

Note that EBIT itself does not include Capital Expenditures, but it does include Depreciation and that is directly linked to CapEx – that’s the link. If a company has a high Depreciation expense, chances are it has a high CapEx.

You use the same methodologies as with public companies: public company comparables, precedent transactions, and DCF. But there are some differences:

• You might apply a 10-15% (or more) discount to the public company comparable multiples because the private company you’re valuing is not as “liquid” as the public comps.

• You can’t use a premiums analysis or future share price analysis because a private company doesn’t have a share price.

• Your valuation shows the Enterprise Value for the company as opposed to the implied per-share price as with public companies.

• A DCF gets tricky because a private company doesn’t have a market capitalization or Beta – you would probably just estimate WACC based on the public comps’ WACC rather than trying to calculate it.

For relative valuation, the methodologies (public comps and precedent transactions) are the same but the metrics and multiples are different:

• You screen based on assets or deposits in addition to the normal criteria.

• You look at metrics like ROE (Return on Equity, Net Income / Shareholders’ Equity), ROA (Return on Assets, Net Income / Total Assets), and Book Value and Tangible Book Value rather than Revenue, EBITDA, and so on.

• You use multiples such as P / E, P / BV, and P / TBV rather than EV / EBITDA.

Rather than a traditional DCF, you use 2 different methodologies for intrinsic valuation:

• In a Dividend Discount Model (DDM) you sum up the present value of a bank’s dividends in future years and then add it to the present value of the bank’s terminal value, usually basing that on a P / BV or P / TBV multiple.

• In a Residual Income Model (also known as an Excess Returns Model), you take the bank’s current Book Value and simply add the present value of the excess returns to that Book Value to value it. The “excess return” each year is (ROE * Book Value) – (Cost of Equity * Book Value) – basically how much the returns exceed your expectations.

You need to use these methodologies and multiples because interest is a critical component of a bank’s revenue and because debt is a “raw material” rather than just a financing source; also, banks’ book values are usually very close to their market caps.

1. Unlike normal valuations, in an IPO valuation we only care about public company comparables.

2. After picking the public company comparables we decide on the most relevant multiple to use and then estimate our company’s Enterprise Value based on that.

3. Once we have the Enterprise Value, we work backward to get to Equity Value and also subtract the IPO proceeds because this is “new” cash.

4. Then we divide by the total number of shares (old and newly created) to get its per-share price. When people say “An IPO priced at…” this is what they’re referring to.

If you were using P / E or any other “Equity Value-based multiple” for the multiple in step #2 here, then you would get to Equity Value instead and then subtract the IPO proceeds from there. 

In a Sum-of-the-Parts analysis, you value each division of a company using separate comparables and transactions, get to separate multiples, and then add up each division’s value to get the total for the company. Example: 

We have a manufacturing division with $100 million EBITDA, an entertainment division with $50 million EBITDA and a consumer goods division with $75 million EBITDA. We’ve selected comparable companies and transactions for each division, and the median multiples come out to 5x EBITDA for manufacturing, 8x EBITDA for entertainment, and 4x EBITDA for consumer goods.

Our calculation would be $100 * 5x + $50 * 8x + $75 * 4x = $1.2 billion for the company’s total value.

“A DCF values a company based on the Present Value of its Cash Flows and the Present Value of its Terminal Value. 

First, you project out a company’s financials using assumptions for revenue growth, expenses and Working Capital; then you get down to Free Cash Flow for each year, which you then sum up and discount to a Net Present Value, based on your discount rate – usually the Weighted Average Cost of Capital.

Once you have the present value of the Cash Flows, you determine the company’s Terminal Value, using either the Multiples Method or the Gordon Growth Method, and then also discount that back to its Net Present Value using WACC.

Finally, you add the two together to determine the company’s Enterprise Value.''

The formula is: Cost of Equity * (% Equity) + Cost of Debt * (% Debt) * (1 – Tax Rate) + Cost of Preferred * (% Preferred). 

In all cases, the percentages refer to how much of the company’s capital structure is taken up by each component.  

For Cost of Equity, you can use the Capital Asset Pricing Model (CAPM – see the next question) and for the others you usually look at comparable companies/debt issuances and the interest rates and yields issued by similar companies to get estimates.

Cost of Equity = Risk-Free Rate + Beta * Equity Risk Premium

The risk-free rate represents how much a 10-year or 20-year US Treasury should yield; Beta is calculated based on the “riskiness” of Comparable Companies and the Equity Risk Premium is the % by which stocks are expected to out-perform “risk-less” assets.

Normally you pull the Equity Risk Premium from a publication called Ibbotson’s. 

Note: This formula does not tell the whole story. Depending on the bank and how precise you want to be, you could also add in a “size premium” and “industry premium” to account for how much a company is expected to out-perform its peers is according to its market cap or industry.

Small company stocks are expected to out-perform large company stocks and certain industries are expected to out-perform others, and these premiums reflect these expectations.

Again, keep in mind our “apples-to-apples” theme. When you look up the Betas on Bloomberg (or from whatever source you’re using) they will be levered to reflect the debt already assumed by each company.

But each company’s capital structure is different and we want to look at how “risky” a company is regardless of what % debt or equity it has. 

To get that, we need to un-lever Beta each time.

But at the end of the calculation, we need to re-lever it because we want the Beta used in the Cost of Equity calculation to reflect the true risk of our company, taking into account its capital structure this time.

You can either apply an exit multiple to the company’s Year 5 EBITDA, EBIT or Free Cash Flow (Multiples Method) or you can use the Gordon Growth method to estimate its value based on its growth rate into perpetuity.

The formula for Terminal Value using Gordon Growth is: Terminal Value = Year 5 Free Cash Flow * (1 + Growth Rate) / (Discount Rate – Growth Rate).

In banking, you almost always use the Multiples Method to calculate Terminal Value in a DCF. It’s much easier to get appropriate data for exit multiples since they are based on Comparable Companies – picking a long-term growth rate, by contrast, is always a shot in the dark.

However, you might use Gordon Growth if you have no good Comparable Companies or if you have reason to believe that multiples will change significantly in the industry several years down the road. For example, if an industry is very cyclical you might be better off using long-term growth rates rather than exit multiples.

You use it to represent the fact that a company’s cash flow does not come 100% at the end of each year – instead, it comes in evenly throughout each year.

In a DCF without mid-year convention, we would use discount period numbers of 1 for the first year, 2 for the second year, 3 for the third year, and so on.

With mid-year convention, we would instead use 0.5 for the first year, 1.5 for the second year, 2.5 for the third year, and so on.

The mechanics are the same as a DCF, but we use dividends rather than free cash flows:

1. Project out the company’s earnings, down to earnings per share (EPS).

2. Assume a dividend payout ratio – what percentage of the EPS actually gets paid out to shareholders in the form of dividends – based on what the firm has done historically and how much regulatory capital it needs.

3. Use this to calculate dividends over the next 5-10 years.

4. Do a check to make sure that the firm still meets its target Tier 1 Capital and other capital ratios – if not, reduce dividends.

5. Discount the dividend in each year to its present value based on Cost of Equity – NOT WACC – and then sum these up.

6. Calculate terminal value based on P / BV and Book Value in the final year, and then discount this to its present value based on Cost of Equity.

7. Sum the present value of the terminal value and the present values of the dividends to get the company’s net present per-share value.

“A merger model is used to analyze the financial profiles of 2 companies, the purchase price and how the purchase is made, and determines whether the buyer’s EPS increases or decreases.

Step 1 is making assumptions about the acquisition – the price and whether it was cash, stock or debt or some combination of those. Next, you determine the valuations and shares outstanding of the buyer and seller and project out an Income Statement for each one.

Finally, you combine the Income Statements, adding up line items such as Revenue and Operating Expenses, and adjusting for Foregone Interest on Cash and Interest Paid on Debt in the Combined Pre-Tax Income line; you apply the buyer’s Tax Rate to get the Combined Net Income, and then divide by the new share count to determine the combined EPS.”

An acquisition is dilutive if the additional amount of Net Income the seller contributes is not enough to offset the buyer’s foregone interest on cash, additional interest paid on debt, and the effects of issuing additional shares.

Acquisition effects – such as amortization of intangibles – can also make an acquisition dilutive.

If the deal involves just cash and debt, you can sum up the interest expense for debt and the foregone interest on cash, then compare it against the seller’s Pre-Tax Income.

And if it’s an all-stock deal you can use a shortcut to assess whether it is accretive (see question #5).

But if the deal involves cash, stock, and debt, there’s no quick rule-of-thumb you can use unless you’re lightning fast with mental math.

Assuming the buyer had unlimited resources, it would always prefer to use cash when buying another company. Why? 

• Cash is “cheaper” than debt because interest rates on cash are usually under 5% whereas debt interest rates are almost always higher than that. Thus, foregone interest on cash is almost always less than additional interest paid on debt for the same amount of cash/debt.

• Cash is also less “risky” than debt because there’s no chance the buyer might fail to raise sufficient funds from investors.

• It’s hard to compare the “cost” directly to stock, but in general stock is the most “expensive” way to finance a transaction – remember how the Cost of Equity is almost always higher than the Cost of Debt? That same principle applies here.

• Cash is also less risky than stock because the buyer’s share price could change dramatically once the acquisition is announced.

Goodwill = Equity Purchase Price – Seller Book Value + Seller’s Existing Goodwill – Asset Write-Ups – Seller’s Existing Deferred Tax Liability + Write-Down of Seller’s Existing Deferred Tax Asset + Newly Created Deferred Tax Liability

A couple notes here:

• Seller Book Value is just the Shareholders’ Equity number.

 You add the Seller’s Existing Goodwill because it gets written down to $0 in an M&A deal.

• You subtract the Asset Write-Ups because these are additions to the Assets side of the Balance Sheet – Goodwill is also an asset, so effectively you need less Goodwill to “plug the hole.”

• Normally you assume 100% of the Seller’s existing DTL is written down.

• The seller’s existing DTA may or may not be written down completely (see the next question).

Stock Purchase, Asset Purchase, and 338(h)(10) Election. The basic differences:

Stock Purchase:

• Buyer acquires all asset and liabilities of the seller as well as off-balance sheet items.

• The seller is taxed at the capital gains tax rate.

• The buyer receives no step-up tax basis for the newly acquired assets, and it can’t depreciate/amortize them for tax purposes.

• A Deferred Tax Liability gets created as a result of the above.

• Most common for public companies and larger private companies.

Asset Purchase:

• Buyer acquires only certain assets and assumes only certain liabilities of the seller and gets nothing else.

• Seller is taxed on the amount its assets have appreciated (what the buyer is paying for each one minus its book value) and also pays a capital gains tax on the proceeds.

• The buyer receives a step-up tax basis for the newly acquired assets, and it can depreciate/amortize them for tax purposes.

• No Deferred Tax Liability is created as a result of the above.

• Most common for private companies, divestitures, and distressed public companies. 

Section 338(h)(10) Election:

• Buyer acquires all assets and liabilities of the seller as well as off-balance sheet items.

• Seller is taxed on the amount its assets have appreciated (what the buyer is paying for each one minus its book value) and also pays a capital gains tax on the proceeds.

• The buyer receives a step-up tax basis for the newly acquired assets, and it can depreciate/amortize them for tax purposes.

• No Deferred Tax Liability is created as a result of the above.

• Most common for private companies, divestitures, and distressed public companies.

• To compensate for the buyer’s favorable tax treatment, the buyer usually agrees to pay more than it would in an Asset Purchase.

“In an LBO Model, Step 1 is making assumptions about the Purchase Price, Debt/Equity ratio, Interest Rate on Debt and other variables; you might also assume something about the company’s operations, such as Revenue Growth or Margins, depending on how much information you have.

Step 2 is to create a Sources & Uses section, which shows how you finance the transaction and what you use the capital for; this also tells you how much Investor Equity is required.

Step 3 is to adjust the company’s Balance Sheet for the new Debt and Equity figures, and also add in Goodwill & Other Intangibles on the Assets side to make everything balance.

In Step 4, you project out the company’s Income Statement, Balance Sheet and Cash Flow Statement, and determine how much debt is paid off each year, based on the available Cash Flow and the required Interest Payments.  

Finally, in Step 5, you make assumptions about the exit after several years, usually assuming an EBITDA Exit Multiple, and calculate the return based on how much equity is returned to the firm.” 

To increase your returns.

Remember, any debt you use in an LBO is not “your money” – so if you’re paying $5 billion for a company, it’s easier to earn a high return on $2 billion of your own money and $3 billion borrowed from elsewhere vs. $3 billion of your own money and $2 billion of borrowed money.

A secondary benefit is that the firm also has more capital available to purchase other companies because they’ve used leverage.

“Ideal” candidates have stable and predictable cash flows, low-risk businesses, not much need for ongoing investments such as Capital Expenditures, as well as an opportunity for expense reductions to boost their margins. A strong management team also helps, as does a base of assets to use as collateral for debt.

The most important part is stable cash flow.

1. Lower the Purchase Price in the model.

2. Raise the Exit Multiple / Exit Price.

3. Increase the Leverage (debt) used.

4. Increase the company’s growth rate (organically or via acquisitions). 5. Increase margins by reducing expenses (cutting employees, consolidating buildings, etc.).

Note that these are all “theoretical” and refer to the model rather than reality – in practice, it’s hard to actually implement these.

“Tenor” is just the fancy word for “How many years will this loan be outstanding?” 

Each type of debt is arranged in order of rising interest rates – so a revolver has the lowest interest rate, Term Loan A is slightly higher, B is slightly higher, Senior Notes are higher than Term Loan B, and so on.

“Seniority” refers to the order of claims on a company’s assets in a bankruptcy – the Senior Secured holders are first in line, followed by Senior Unsecured, Senior Subordinated, and then Equity Investors.

“Floating” or “Fixed” Interest Rates: A “floating” interest rate is tied to LIBOR. For example, L + 100 means that the interest rate of the loan is whatever LIBOR is at currently, plus 100 basis points (1.0%). A fixed interest rate, on the other hand, would be 11%. It doesn’t “float” with LIBOR or any other rate.

Amortization: “straight line” means the company pays off the principal in equal installments each year, while “bullet” means that the entire principal is due at the end of the loan’s lifecycle. “Minimal” just means a low percentage of the principal each year, usually in the 1-5% range.

Call Protection: Is the company prohibited from “calling back” – paying off or redeeming – the security for a certain period? This is beneficial for investors because they are guaranteed a certain number of interest payments.

This scenario is admittedly rare, but it could happen if the increase leverage increases interest payments or debt repayments to very high levels, preventing the company from using its cash flow for other purposes.

Sometimes in LBO models, increasing the leverage increases the IRR up to a certain point – but then after that the IRR starts falling as the interest payments or principal repayments become “too big.” 

For this scenario to happen you would need a “perfect storm” of:

1. Relative lack of cash flow / EBITDA growth.

2. High interest payments and principal repayments relative to cash flow.

3. Relatively high purchase premium or purchase multiple to make it more difficult to get a high IRR in the first place.

First, fill the 3 liter bucket and pour it into the 5 liter one. Then, re-fill the 3 liter bucket and pour it into the 5 liter bucket until it’s full – that leaves 1 liter in the 3 liter bucket and 5 in the 5 liter bucket.

Then, pour out the 5 liter bucket so nothing is left and pour the 1 liter of water from the 3 liter bucket into the 5 liter bucket. Finally, fill the 3 liter bucket completely and pour it into the 5 liter bucket – since it already has 1 liter of water, you’ll get exactly 4 liters.

For this type of question, it’s easiest to use deductive reasoning to get the answer. You know you can’t possibly get 4 liters of water in the 3 liter bucket – it has to be in the 5 liter bucket.

Since you can easily get 3 liters of water, that tells you that the “trick” will involve isolating the remaining 1 liter and getting it into the 5 liter bucket. So then the question comes down to how to get the 1 liter of water in the 3 liter bucket. You know it has to involve pouring water into the 5 liter bucket, and that leads you in the right direction.