Three Tough Investment Banking Technical Questions

Three months ago we did a bit of a deep dive into artificial intelligence (drawing from a long primer that Morgan Stanley had just put out) and mentioned that the immediate winners would likely have three attributes. First, they’d have reams of data available to immediately begin training their models on. Second, they’d have the technical expertise and infrastructure to scale up and integrate new offerings into their existing offerings. Third, they’d have nearly endless cash that they could deploy.

Morgan Stanley called the six that (mostly) fit the above three attributes the “AI Enablers” which comprised Alphabet, Amazon, Meta, Microsoft, Nvidia, and Apple.

In some respects it seemed like we were writing that post at the peak of the AI hype: with the release of GPT-4, there were endless articles in the mainstream press and bubble-like commentary in a lot of the equity research that was coming out (with price targets being magically revised higher by double-digit percentages overnight).

However, as you no doubt know, it turned out that the hype cycle was just beginning back in March (at least if you view public returns as a proxy for how hyped something is or not).

Even though the Fed has continued raising rates this year – which, given that tech companies tend to have most of their cash flows coming far into the future, should be net negative for valuations – the performance of anything that seems likely to benefit from AI is being bid up dramatically.

Indeed, as this fantastic slide from Deutsche Back illustrates, the primary reason for the (relatively) modest gains we’ve seen in public markets this year are the incredible gains in the tech sector broadly (but more specifically anything touching artificial intelligence).

If you find yourself in any interviews (or in a group placement process) being asked a more open-ended question about themes or trends that are impacting the tech sector, you may be a bit hesitant to talk about AI given the hype cycle we’re currently in.

However, even though it’s an obvious topic to bring up, with the prior post we did, along with the Morgan Stanley primer, you’ll have sufficiently in-depth talking points to really stand out (e.g., be able to discuss who you think the winners are, that many acqui-hires will be taking place, etc.). You can also talk about the intersection of AI with the broader chip wars that we discussed a while ago too as they’re very much intertwined.

Anyway, we just wanted to do a brief little update on AI in case some haven’t seen the prior post. But since it’s been quite a few months since we’ve talked about classic interview questions – which will still be the most important part of your interviews! – let’s go over some more difficult technical questions that are group agnostic.

Investment Banking Technical Questions

As we’ve tried to stress in many of our posts, having a loose grasp of the tech, media, and telecom sectors (i.e., knowing the major sub-sectors, knowing a few specific multiples, knowing a few themes, etc.) helps you stand out. But the majority of your interviews will still revolve around technical questions, and for the most competitive groups in banking the technical difficulty tends to be ratcheted up quite a bit.

• Let’s say we bought some specialized equipment that we need in order to make a new widget. This equipment was bought for $100 and was presumed to have no salvage value. We initially thought the equipment would have a useful life of ten years, and we entirely financed the purchase with debt at an interest rate of 10%. However, in year four our widget became obsolete, and we wrote down our equipment since it was specialized and couldn’t be repurposed. Can you walk me through the three statements in year four?
• Let’s say that a company has securities classified as Available for Sale (AFS) that increase in value by $100. Can you walk me through how this is handled on the three statements?
• Let’s say that ParentCo has an EV of $100, equity value of $80, debt of $80, and cash of $60. It also has EBITDA of $10 and net income of $6. After significant due diligence, it decides to acquire TargetCo which has an EV of $40, equity value of $40, EBITDA of $4, and net income of $2. If the acquisition was entirely funded by debt, at a 10% coupon, what is the pro-forma EV/EBITDA and P/E ratio?

Let’s say we bought some specialized equipment that we need in order to make a new widget. This equipment was bought for $100 and was presumed to have no salvage value. We initially thought the equipment would have a useful life of ten years, and we entirely financed the purchase with debt at an interest rate of 10%. However, in year four our widget became obsolete, and we wrote down our equipment since it was specialized and couldn’t be repurposed. Can you walk me through the three statements in year four?

In the past few years accounting technicals have evolved such that you’re increasingly asked to walk through the three statements in future years, as opposed to the current year, to make things a little bit trickier. So, before answering a question like this, it’s worth taking a few moments to set the stage...

First, we know that the amount the equipment will be written down won’t be $100 as the equipment will have been depreciated for three years prior to when the write down occurs. Second, we shouldn’t assume that any debt is being paid back here. Sometimes interviewees will assume, axiomatically, that if debt is raised to fund x, and then x is written down, that the debt must be repaid. But that often isn’t the case, and we’ll assume it's not here.

With that said, we haven’t been told the type of debt that’s been raised here. And, depending on the type of debt, it could have amortization (i.e., if it’s a TLB) which needs to be accounted for given that it (obviously) represents a real cash outflow. Here we’ll assume there’s no amortization, and you may want to explicitly state that before getting into your answer in an interview.

So, with all that said, let’s get started with the income statement impact...

In year four we would have had three years of depreciation at $10 per year ($100 of equipment, since we assumed no salvage value, depreciated over ten years). So we’re left with $70 that we’ll need to write down. In year four we’ll also have $10 in cash interest expense ($100 of debt at 10% interest).

Since we’re assuming no amortization is occurring, this is all we need to deal with on the income statement. So pre-tax income falls by $80 and, assuming a 20% tax rate, net income falls by $64.

Moving to the cash flow statement, cash is down $64 but we need to add back the write down of $70 since it’s a non-cash expense. Therefore, cash flow from operations is up by $6. And, since we’re assuming no debt is being paid back, we’ll have no other changes on our cash flow statement.

Finally, on the balance sheet we’ll have cash up by $6. We’ll then have PP&E down by $70 reflecting the asset write down – thereby leaving out asset side down by $64. On the liabilities and shareholders’ equity side, debt isn’t being touched but we’ll have retained earnings down by $64 (flowing in from our income statement). Therefore, we’re in balance.

Let’s say that a company has securities classified as Available for Sale (AFS) that increase in value by $100. Can you walk me through how this is handled on the three statements?

In recent months there’s been ceaseless discussion about the accounting treatment of Held-to-Maturity (HTM) securities given that they were at the heart of the mini banking “crisis” that took place (taking down, among others, Silicon Valley Bank).

Apparently, many people just figured out that HTM securities don’t require realizing gains or losses intermittently or marking-to-market given that they are, by definition, supposed to be held to maturity (despite this reality always being carefully footnoted and being something that at least should have been known by all market participants).

Anyway, as you likely know, you can treat a security as Held for Trading (HFT), Available for Sale (AFS), or Held-to-Maturity (HTM). I won’t bore you with the definitions as they’re covered in the accounting guide, or you can just Google them. Suffice to say, AFS securities are a bit of a catchall between HTF and HTM: basically representing securities that you’re not considering current assets but that you’re also not committing to holding to maturity.

Given this, unrealized gains and losses aren’t placed on the income statement. Rather, they’re placed within Accumulated Other Comprehensive Income (AOCI) that’s housed within shareholders’ equity. AFS securities will be marked-to-market before each reporting period. So, to be clear, gains and losses are being captured – they’re just being captured within the context of the balance sheet not the income statement.

So, in this example, there will be no change to the income statement. On the cash flow statement, there will also be no change as there’s been, obviously, no change in cash. However, on the balance sheet you’ll have an investment-related line item (i.e., short-term investments) increase by $100 on the asset side. This will be balanced by having an increase of $100 within AOCI on the liabilities and shareholders’ equity side.

Let’s say that ParentCo has an EV of $100, equity value of $80, debt of $80, and cash of $60. It also has EBITDA of $10 and net income of $6. After significant due diligence, it decides to acquire TargetCo which has an EV of $40, equity value of $40, EBITDA of $4, and net income of $2. If the acquisition was entirely funded by debt, at a 10% coupon, what is the pro-forma EV/EBITDA and P/E ratio?

There’s a lot going on here. So if you get a question like this, make sure you’ve taken the time to write everything out clearly (i.e., make a table with the ParentCo and TargetCo data separated).

The first thing you should be doing is finding the combined EV. We have ParentCo EV of $100 and we’ll assume that TargetCo is acquired for its EV of $40 – consequently, since we’ve been told the acquisition will be entirely funded by debt, this means we have a debt increase of $40. So, the combined EV here will be $140 ($80 market cap of ParentCo + $80 in ParentCo debt + $40 new ParentCo debt - $60 in cash).

Note: Conceptually the EV of TargetCo is being captured by the $40 increase in debt (given that TargetCo was acquired using exclusively debt).

The combined EBITDA – found just by adding the ParentCo EBITDA and TargetCo EBITDA together – will just be $14 assuming no synergies, etc. Therefore, the pro-forma EV/EBITDA multiple will be $140/$14 of 10x.

Moving onto the pro-forma P/E calculation, things get a bit trickier. The overall market cap will be unchanged at $80 (think back to the pro-forma EV calculation we did). But, since we funded this acquisition purely through debt issuance, we can’t just add the two net incomes together (since we’re going to have a higher pro-forma interest expense!).

To figure out the right pro-forma net income, we just need to find the enhanced interest expense we’re incurring here. Since we have $40 in new debt at a 10% coupon, we have $4 in additional cash interest per year. Assuming a 20% tax rate, this causes a decline in combined net income of $3.2. Therefore, the combined net income can be thought of as $6 + $2 - $3.2 = $4.8 (in other words, the combined net incomes minus the amount of additional cash interest expense incurred as a result of the transaction).

Putting this all together, our pro-forma P/E ratio will be $80/$4.8 or 16.67x (there’s no need to worry about giving exact answer when the math isn’t straight-forward, you can just say since 80/5 is 16, and 4.8 is slightly below 5, then the multiple will be a bit above 16x).

Conclusion

The majority of technicals you’ll face in an interview aren’t going to be quite as involved as these have been. However, there’s no getting around the fact that technicals have gotten much more difficult over the past five years or so.

Fortunately, all technicals are built off the same foundational concepts and the difficulty of today’s questions comes mostly from an interviewee having to handle more variables at once or work through the impact on the three statements in future years. Therefore, building a strong foundation (especially in accounting) will pay dividends for handling these more difficult technicals.

Finally, even though we’ve said this in many other posts, it’s worth reiterating again: it makes a difference to show you have a real, tangible interest in TMT during interviews, and are able to speak to slightly more niche areas (i.e., semiconductors, hardware, etc.).

But the majority of your interviews – even at a place like Qatalyst that values having a deep sector interest – will still revolve around answering accounting and valuation technicals, and you need to get all (or almost all) of them right to land the offer. So even though it can seem repetitive to go through endless technicals, keep on practicing!