Finance

Handbook
 Financial Statements 1

Equity Value 11

Valuations
Contents

18

DCF 30

Merger Model 36

Stock 51

Brain Teasers 58

References 64
 Financial
Statements

1
 Easy

QUESTION 1
Walk me through the 3 financial statements.

ANSWER 1
The three major financial statements are:
1. Income Statement
2. Balance Sheet
3. Cash Flow Statement

The Income Statement gives the company’s revenue and expenses

and goes down to Net Income as the final line on the statement.
The Balance Sheet shows the company’s Assets – its resources –
such as Cash, Inventory and PP&E, as well as its Liabilities – such as
Debt and Accounts Payable – and Shareholders’ Equity. Assets must
equal Liabilities plus Shareholders’ Equity.
The Cash Flow Statement begins with Net Income, adjusts for non-
cash expenses, and working capital changes, and then lists cash
flow from investing and financing activities; at the end, you see the
company’s net change in cash.

Financial Statements
2
 Easy

QUESTION 2
How do the three primary financial statements interrelate?

ANSWER 2
The income statement computes net income, which links to the
balance sheet through retained earnings, modified for dividends.
This net income serves as the starting point for the Cash Flow
Statement, which is utilized to determine cash flow from operating
activities. Depreciation—considered a non-cash expense—reduces
net income on the Income Statement, affects the Balance Sheet by
decreasing the value of property, plant, and equipment (PP&E), and
is added back to operational cash flow on the Cash Flow
Statement. Changes in working capital, which involve current
assets and liabilities, also link the Balance Sheet to cash flows from
operations. Financing activities such as debt issuance have
implications for both the Balance Sheet and the Cash Flow
Statement. These connections offer a holistic perspective on
financial health.

Financial Statements
3
 Easy

QUESTION 3
If I were stranded on a desert island, only had 1 statement
and I wanted to review the overall health of a company –
which statement would I use and why?

ANSWER 3
You would use the Cash Flow Statement because it gives a true
picture of how much cash the company generates, independent of
all the non-cash expenses you might have. And that’s the #1 thing
you care about when analyzing the overall financial health of any
business – its cash flow.

QUESTION 4
If Depreciation is a non-cash expense, why does it affect the
cash balance?

ANSWER 4
Although Depreciation is a non-cash expense, it is tax-deductible.
Since taxes are a cash expense, Depreciation affects cash by
reducing the amount of taxes you pay.

Financial Statements
4
 Easy

QUESTION 5

What is Working Capital? How is it used?

ANSWER 5

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)
tells 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.

Financial Statements
5
 Easy

QUESTION 6
What does negative Working Capital mean? Is that a bad
sign?

ANSWER 6
Not necessarily. It depends on the type of company and the
specific situation – here are a few different things it could mean :
1. Some companies with subscriptions or longer-term contracts
often have negative Working Capital because of high Deferred
Revenue balances.
2. Retail and restaurant companies like Amazon, Wal-Mart, and
McDonald’s often have negative Working Capital because
customers pay upfront – so they can use the cash generated to pay
off their Accounts Payable rather than keeping a large
cash balance on-hand. This can be a sign of business efficiency.
3. In other cases, negative Working Capital could point to financial
trouble or possible bankruptcy (for example, when customers don’t
pay quickly and upfront and the company is carrying a high debt
balance).

Financial Statements
6
 Medium

QUESTION 7
Walk me through how Depreciation going up by $10 would
affect the statements.

ANSWER 7

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 go 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.

Financial Statements
7
 Hard

QUESTION 8
A company buys a factory for $200 using $200 of Debt.
What happens INITIALLY on the statements?

ANSWER 8
Income Statement: No changes.
Cash Flow Statement: There’s no net change in cash because the
$200 factory purchase counts as CapEx, which reduces cash flow,
and the $200 Debt issuance is a cash inflow.
Balance Sheet: PP&E is up by $200, so the Assets side is up by
$200, and Debt is up by $200, so the L&E side is up by $200, and
the Balance Sheet stays balanced.
Intuition: An Asset increases and a Liability increases to balance it,
and there are no tax effects.

Financial Statements
8
 Hard

QUESTION 9
What do you Mean by Adjustment Entries? Why do we Pass
Them?

ANSWER 9
The entries we pass at the end of every accounting period to the
nominal and related accounts so we can indicate the correct profit
and loss in the profits and loss accounts and keep the balance
sheet accurate, are called adjustment entries. It is crucial to
passing adjustment before we prepare the final financial
statements as in their absence the final statements would reflect
incorrect information resulting in error and confusion. Moreover, the
balance sheet wouldn’t show the accurate position of the business
if we don’t pass the adjustment entries.

Financial Statements
9
 Hard

QUESTION 10
What is the Difference Between a Journal Entry and a
Ledger?

ANSWER 10
The journal is the book of prime entry and all the transactions are
recorded in it to show which account got debited and which one
got credited. However, the ledger is the book for keeping separate
accounts. You’d have to classify the recorded transactions in a
journal and add them to the dedicated accounts present in the
ledger. The ledger is also known as the book of final entry.

Financial Statements
10
Equity
Value

11
 Easy

QUESTION 1

Why do we look at both Enterprise Value and Equity Value?

ANSWER 1

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.

QUESTION 2

What’s the formula for Enterprise Value?

ANSWER 2

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

– Cash

Equity Value
12
 Easy

QUESTION 3

Could a company have a negative Enterprise Value? What

would that mean?
ANSWER 3

Yes. It means that the company has an extremely large cash

balance, or an extremely low market capitalization (or both). You
see it with: 1. Companies on the brink of bankruptcy. 2. Financial
institutions, such as banks, that have large cash balances – but
Enterprise Value is not even used for commercial banks in the first
place so this doesn’t matter much.

QUESTION 4

What’s the difference between Equity Value and

Shareholders’ Equity?

ANSWER 4

Equity Value is the market value, and Shareholders’ Equity is the

book value. Equity Value can never be negative because shares
outstanding and share prices can never be negative, whereas
Shareholders’ Equity could be any value. For healthy companies,
Equity Value usually far exceeds Shareholders’ Equity.

Equity Value
13
 Medium

QUESTION 5

What percentage dilution in Equity Value is “too high?”

ANSWER 5

There’s no strict “rule” here but most bankers would say that
anything over 10% is odd. If your basic Equity Value is $100 million
and the diluted Equity Value is $115 million, you might want to check
your calculations – it’s not necessarily wrong, but over 10% dilution is
unusual for most companies.

Equity Value
14
 Medium

QUESTION 6

You never use Equity Value / EBITDA, but are there any
cases where you might use Equity Value / Revenue?

ANSWER 6

It’s very rare to see this, but sometimes large financial institutions
with big cash balances have negative Enterprise Values – so you
might use Equity Value / Revenue instead. You might see Equity
Value / Revenue if you’ve listed a set of financial institutions and
non-financial institutions on a slide, you’re showing Revenue
multiples for the non financial institutions, and you want to show
something similar for the financial institutions. Note, however, that
in most cases you would be using other multiples such as P/E and
P/BV with banks anyway.

Equity Value
15
 Medium

QUESTION 7

Why does Enterprise Value NOT necessarily represent the

"true cost" to acquire a company?

ANSWER 7

First, because the treatment of the seller’s existing Debt and Cash
differs based on the terms of the deal. The buyer may not
necessarily “repay” the seller’s Debt – it could instead refinance it
and replace it with new Debt – and it may not “get” all the seller’s
Cash. Also, the buyer has to pay additional fees for the M&A
advisory, accounting, and legal services, and the financing to
acquire another company, and those are not reflected in its
Enterprise Value.

Equity Value
16
 Medium

QUESTION 8
Would a seller prefer a stock purchase or an asset
purchase? What about the buyer?

ANSWER 8
A seller almost always prefers a stock purchase to avoid double
taxation and to get rid of all its liabilities. The buyer almost always
prefers an asset deal so it can be more careful about what it
acquires and to get the tax benefit from being able to deduct
depreciation and amortization of asset write-ups for tax purposes.

QUESTION 9
If you owned a small firm that had become somewhat
established, but you needed a large amount of financial
capital to carry out a major expansion, would you prefer to
raise the funds through borrowing or by issuing stock?
Explain your choice.

ANSWER 9

Small firms would prefer borrowing either from banks or venture

capitalists. Issuing stocks won’t be able to raise sufficient funds
since the firm is new and the public has little to no confidence in
the future profits. Moreover, a small start-up firm won’t have
enough profits to distribute as dividends to its shareholders. Issuing
stocks is also an expensive process. The bank can, however, monitor
sales and expenses quite accurately by looking at deposits and
withdrawals and extending funds. The great advantage of
borrowing money is that the firm maintains control of its operations
and is not subject to shareholders. Similarly, a venture capital fund
may provide funds and advice to these small firms.

Equity Value
17
 Hard

QUESTION 10
If the formula for Enterprise Value is:
EV = Equity Value + Debt + Preferred Stock +
Noncontrolling Interest – Cash
Are there any problems with this formula for Enterprise
Value?

ANSWER 10

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 must convert
operating leases to capital leases and add them.
• Unfunded Pension Obligations – Sometimes, these are also
counted as debt.
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…

Equity Value
18
Valuation

19
 Easy

QUESTION 1

What are the 3 major valuation methodologies?

ANSWER 1

Comparable Companies, Precedent Transactions and Discounted

Cash Flow Analysis.

QUESTION 2

When would you not use a DCF in a Valuation?

ANSWER 2

You do not use a DCF if the company has unstable or

unpredictable cash flows, such as in the case of tech or biotech
startups, or when debt and working capital serve fundamentally
different roles. For example, banks and financial institutions do not
reinvest debt, and working capital is a significant part of their
balance sheets—so you wouldn’t use a DCF for such companies.

Valuation
20
 Easy

QUESTION 3

The EV / EBIT, EV / EBITDA, and P / E multiples all measure a

company’s profitability. What’s the difference between
them, and when do you use each one?

ANSWER 3

P/E depends on the company’s capital structure, whereas EV/EBIT

and EV/EBITDA are capital structure-neutral. Therefore, you use
P/E for banks, financial institutions, and other companies where
interest payments/expenses are critical.
EV/EBIT includes Depreciation & Amortization, whereas EV/EBITDA
excludes it. You’re more likely to use EV/EBIT in industries where
D&A is large and where capital expenditures and fixed assets are
important (e.g., manufacturing). In contrast, EV/EBITDA is more
suitable for industries where fixed assets are less important and
where D&A is comparatively smaller (e.g., Internet companies).

Valuation
21
 Medium

QUESTION 4
What’s the point of valuation? WHY do you value a
company?

ANSWER 4
You value a company to determine its Implied Value based on your
analysis. If this Implied Value significantly differs from the
company’s Current Value, there may be an investment opportunity
to profit if the market adjusts its valuation. When advising a client
company, you might conduct a valuation to inform management of
the potential sale price, which often differs from the Current Value
due to factors such as market perception, strategic value, or future
growth potential.

QUESTION 5
Can you use private companies as part of your valuation?

ANSWER 5

Precedent transactions are only relevant in their specific context.

Including them in public company comparables or in the Cost of
Equity/WACC calculation for a DCF would not make sense
because they involve private companies that lack market
capitalization and Beta values, which are essential for these
analyses.

Valuation
22
 Medium

QUESTION 6

What are the advantages and disadvantages of the 3 main

valuation methodologies?

ANSWER 6

Public Comps are valuable because they rely on real market data,
are quick to calculate and explain, and don’t depend on long-term
assumptions. However, they may be less accurate for volatile or
thinly traded companies, may lack truly comparable peers, and can
undervalue a company’s long-term potential.
Precedent Transactions are useful as they reflect actual prices paid
in acquisitions and often capture industry trends better than Public
Comps. However, the data can be inconsistent or misleading,
comparable transactions may be scarce, and specific deal terms or
market conditions can distort the multiples.
According to finance theory, DCF Analysis is considered the most
“accurate” method, as it’s less influenced by market fluctuations
and accounts for company-specific factors and long-term trends.
However, it relies heavily on far-future assumptions, and there is
often disagreement on key inputs such as the Cost of Equity and
WACC.

Valuation
23
 Medium

QUESTION 7

I have one company with a 40% EBITDA margin trading at 8x

EBITDA, and another company with a 10% EBITDA margin
trading at 16x EBITDA. What’s the problem with comparing
these two valuations directly?

ANSWER 7

There’s no strict "rule" against comparing companies with

significantly different margins, but it can be misleading. Basic
arithmetic often results in companies with higher margins (e.g.,
40%) having lower EBITDA multiples, regardless of their actual
value. In such cases, it’s advisable to screen based on margins and
exclude outliers, rather than attempting to "normalize" EBITDA
multiples by adjusting for margin differences.

Valuation
24
 Hard

QUESTION 8

Which of the 3 main methodologies will produce the highest

Implied Values?

ANSWER 8

This is a trick question because almost any valuation methodology

could produce the highest Implied Values, depending on the
industry, period, and assumptions used. Precedent Transactions
often generate higher Implied Values than Public Comps due to the
control premium—the extra amount acquirers must pay to obtain
control of a company. However, it's difficult to directly compare
these with a DCF, as the latter is far more dependent on the
assumptions made.

The safest answer is: “A DCF tends to produce the most variable
output due to its sensitivity to assumptions, while Precedent
Transactions typically produce higher values than Public Comps
because of the control premium.”

Valuation
25
 Hard

QUESTION 9

Would it ever make sense to use a negative Terminal FCF

Growth Rate?
ANSWER 9

Yes.For example, when valuing a biotech or pharmaceutical

company whose key drug patent expires within the forecast period,
it may be reasonable to assume that the company will not fully
replace the lost revenue, leading to declining cash flows. A
negative Terminal FCF Growth Rate reflects the expectation that
the company’s cash flow will eventually decline or cease, even if
this occurs decades in the future. This doesn’t render the company
“worthless”; rather, it means the company is simply worth less.

Valuation
26
 Hard

QUESTION 10

What’s one problem with using TEV / EBITDA multiples to

calculate Terminal Value?

ANSWER 10

The biggest issue with using EBITDA is that it ignores CapEx. Two
companies with similar TEV/EBITDA multiples may have significantly
different Free Cash Flow and FCF growth figures, leading to
varying Implied Values, despite having similar multiples. You may
achieve better results using TEV/EBIT, TEV/NOPAT, or
TEV/Unlevered FCF, but these multiples introduce other challenges,
such as reduced comparability across peer companies. This issue is
one reason why the Gordon Growth Method is still considered the
“true” method for calculating Terminal Value.

Valuation
27
 Hard

QUESTION 11

Why might you include a “stub period” in a DCF, and what

does it mean?

ANSWER 11

You might include a "stub period" when valuing a company midway

through the year, particularly if it has already reported part of its
financial results. Since a DCF is based on expected future cash
flows, you should subtract the already-reported results and adjust
the discount periods accordingly.

For example, if it’s September 30th and the company’s fiscal year
ends on December 31st, the company’s future cash flow for the year
will be generated from September 30th to December 31st.
Therefore, you should exclude the cash flow from January 1st to
September 30th in your projections, as that period has already
passed. In the first year, you would only include the projected FCF
for the period from September 30th to December 31st. To discount
the FCF for these 3 months, you would use a 0.25 discount factor,
as 3 months is 25% of the year. For the following year, you would
use 1.25, then 2.25 for the year after that, and so on.

Valuation
28
 Hard

QUESTION 12

Should the Cost of Equity and WACC be higher for a $5

billion or $500 million Equity Value company?

ANSWER 12

Assuming both companies have the same capital structure

percentages, the Cost of Equity and WACC should be higher for
the $500 million company. All else being equal, smaller companies
generally offer higher potential returns but also come with higher
risk compared to larger companies, which explains why the Cost of
Equity will be higher. Additionally, since smaller companies have a
higher risk of defaulting on their debt, their Cost of Debt (and Cost
of Preferred Equity) tends to be higher as well.
Because all these costs are higher for smaller companies, WACC
should also be higher, assuming the same capital structure
percentages.

Valuation
29
 Hard

QUESTION 13

Would increasing the revenue growth from 9% to 10% or

increasing the Discount Rate from 9% to 10% make a bigger
impact on a DCF?

ANSWER 13

The increase in the Discount Rate will have a much larger impact.
While raising the revenue growth from 9% to 10% will only slightly
affect the FCF and Terminal Value, the Discount Rate affects the
Present Value of all future cash flows. A difference between 9%
and 10% in the discount rate is significant, as it will have a much
larger impact on the overall valuation.

QUESTION 14

What impact does the Normalized Terminal Year make?

ANSWER 14

In most cases, the Normalized Terminal Year will reduce a

company’s Implied Value because you typically adjust the
company’s growth rates and margins in this year. Additionally, you
remove non-cash adjustments that may have benefited the
company in prior periods, which further impacts the valuation.

Valuation
30
DCF

31
 Easy

QUESTION 1

Walk me through a DCF.

ANSWER 1

A DCF values a company based on the Present Value of its Cash

Flows and Terminal Value.
First, you project the company’s financials using assumptions for
revenue growth, expenses, and working capital. Then, you calculate
Free Cash Flow for each year, sum them up, and discount them to
Net Present Value using your discount rate—typically the Weighted
Average Cost of Capital (WACC).Once you have the present value
of the cash flows, you calculate the company’s Terminal Value
using either the Multiples Method or the Gordon Growth Method.
This terminal value is also discounted back to its Net Present
Valueusing WACC.Finally, you add the present value of the cash
flows and the present value of the terminal value to determine the
company’s Enterprise Value.

QUESTION 2
How do you calculate WACC?
ANSWER 2
The formula is: Cost of Equity * (% Equity) + Cost of Debt * (%
Debt) * (1 – Tax Rate) + Cost of Preferred * (% Preferred).

DCF
32
 Easy

QUESTION 3

What is Beta?

ANSWER 3

Beta (β) represents the relative volatility or risk of an investment

compared to the overall market.
1. β < 1 indicates the investment is less volatile than the market
(lower risk, lower reward).
2. β > 1 indicates the investment is more volatile than the market
(higher risk, higher reward).
3. A beta of 1.2 means the investment is theoretically 20% more
volatile than the market. If the market increases by 10%, the
investment is expected to rise by 12%.

QUESTION 4

How do you calculate the Cost of Equity?

ANSWER 4

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

DCF
33
 Medium

QUESTION 5

People say that the DCF is intrinsic valuation, while Public

Comps and Precedent Transactions are relative valuation. Is
that correct?

ANSWER 5

The DCF is based on a company’s expected future cash flows,

which classifies it as an intrinsic valuation method. However, the
Discount Rate used in the DCF is typically derived from market
data, often linked to peer companies. Additionally, if you use the
Multiples Method for calculating Terminal Value, the multiples are
also based on market comparables. While the DCF relies less on
market data than other valuation methodologies, there is still some
market influence. It is more accurate to say that the DCF is
primarily based on your views of the company’s long-term prospects
and less reliant on market data compared to other methods.

DCF
34
 Hard

QUESTION 6

What is the difference between the APV and WACC?

ANSWER 6

WACC incorporates the effect of tax shields into the discount rate
used to calculate the present value of cash flows. It is typically
calculated using actual data from balance sheets of companies or
industries.
APV adds the present value of financing effects—most commonly
the debt tax shield—to the net present value calculated under the
assumption of an all-equity value, resulting in the adjusted present
value. The APV approach is particularly useful in situations where
the cost of financing is more complex, such as in a leveraged
buyout (LBO).

DCF
35
 Hard

QUESTION 7

Suppose you’re calculating WACC for two similarly sized

companies in the same industry, but one company is in a
developed market (DM), and the other is in an emerging
market (EM). Will the EM company always have a higher
WACC?

ANSWER 7

It’s generally true that certain components of WACC, such as the

Risk-Free Rate, Equity Risk Premium, and Cost of Debt, tend to be
higher for an Emerging Market (EM) company. WACC should also
be higher if the leveraged beta for the EM company is similar to or
higher than that of a developed market company, and the capital
structure percentages are identical. However, there may be cases
where differences in capital structure or unusual results for
leveraged beta could lead to a comparable or lower WACC for the
EM company.
For example, if the government heavily regulates the industry of the
EM company, the leveraged beta might be lower due to reduced
volatility in the market.

DCF
36
Merger
Model

37
 Easy

QUESTION 1

What’s the difference between a merger and an acquisition?

ANSWER 1

A merger occurs when two companies of similar size combine to

form a new entity with shared ownership and control, often to
create synergies and expand market presence. It involves blending
cultures and decision-making, as seen in the Disney-Pixar merger.
An acquisition, on the other hand, happens when one company
takes over another by purchasing its assets or shares, giving the
acquirer full control. Unlike mergers, no new entity is formed, and
the target company may either be absorbed or retain its name, as
demonstrated by Facebook’s acquisition of Instagram.
In essence, mergers are about partnership, while acquisitions are
focused on control.

Merger Model
38
 Easy

QUESTION 2

What is the difference between Goodwill and Other

Intangible Assets?

ANSWER 2

Goodwill typically remains the same over many years and is not
amortized. It only changes in the event of goodwill impairment or a
subsequent acquisition.
In contrast, Other Intangible Assets are amortized over several
years and affect the Income Statement by reducing Pre-Tax
Income. There is also a distinction in what each represents, but this
level of detail is rarely explored by bankers—accountants and
valuation specialists are the ones responsible for assigning these
items accurately.

Merger Model
39
 Easy

QUESTION 3

Why would a company want to acquire another company?

ANSWER 3

Several possible reasons:

1. The buyer wants to gain market share by buying a competitor.
2. The buyer needs to grow more quickly and sees an acquisition
as a way to do that.
3. The buyer believes the seller is undervalued.
4. The buyer wants to acquire the seller’s customers so it can up-
sell and cross-sell to them.
5. The buyer thinks the seller has a critical technology, intellectual
property or some other “secret sauce” it can use to significantly
enhance its business.
6. The buyer believes it can achieve significant synergies and
therefore make the deal accretive for its shareholders.

Merger Model
40
 Easy

QUESTION 4

What are synergies, and can you provide a few examples?

ANSWER 4

Synergies refer to situations where 2 + 2 = 5 (or 6, or 7…) in an

acquisition, meaning the buyer derives more value from the
acquisition than what the financials alone would predict.
There are two types of synergies: revenue synergies and cost (or
expense) synergies.
1. Revenue Synergies: The combined company can cross-sell
products to new customers or up-sell additional products to
existing customers. It may also gain the ability to expand into
new geographies as a result of the acquisition.
2. Cost Synergies: The combined company can consolidate office
spaces and administrative functions, lay off redundant
employees, or shut down unnecessary stores or locations to
reduce costs.

Merger Model
41
 Medium

QUESTION 5

How much debt could a company issue in a merger or

acquisition?

ANSWER 5

Generally, you would look at Comparable Companies or Precedent

Transactions to determine this. You would use the combined
company’s LTM (Last Twelve Months) EBITDA figure, find the median
Debt/EBITDA ratio of the companies you’re analyzing, and apply
that ratio to your own EBITDA figure to estimate how much debt
you could raise. You would also examine Debt Comparables for
companies in the same industry to see the types of debt they have
used and how many tranches they have structured.

Merger Model
42
 Medium

QUESTION 6

How do you take into account NOLs in an M&A deal?

ANSWER 6

You apply Section 382 to determine how much of the seller’s NOLs
(Net Operating Losses) are usable annually. The formula is:
Allowable NOLs = Equity Purchase Price * Highest Adjusted Long-
Term Rate of the Past 3 Months.
For example, if the equity purchase price is $1 billion and the
highest adjusted long-term rate is 5%, the allowable NOLs would
be: $1 billion * 5% = $50 million per year. If the seller had $250
million in NOLs, the combined company could use $50 million
annually for 5 years to offset taxable income.

Merger Model
43
 Medium

QUESTION 7

What’s an Earnout and why would a buyer offer it to a seller

in an M&A deal?

ANSWER 7

An Earnout is a form of deferred payment in an M&A deal,

commonly used with private companies and start-ups but rarely
seen with public sellers. The payment is typically contingent on
meeting specific financial performance or operational goals.
For example, a buyer might offer:
"We’ll pay an additional $10 million in 3 years if revenue reaches
$100 million by that time."
Earnouts serve to incentivize sellers to maintain strong performance
post-acquisition and prevent management teams from taking the
upfront payment and disappearing, ensuring continued
commitment to the business.

Merger Model
44
 Medium

QUESTION 8

What is an exchange ratio and when would companies use it

in an M&A deal?

ANSWER 8

An exchange ratio is an alternate way of structuring a 100% stock

M&A deal or any M&A deal with a portion of stock involved.
Suppose you buy a company for $100 million in an all-stock deal.
Normally, you would determine how much stock to issue by dividing
the $100 million by the buyer’s stock price and using that to get the
new share count. With an exchange ratio, by contrast, you would tie
the number of new shares to the buyer’s shares – so the seller might
receive 1.5 of the buyer’s shares for each of its shares rather than
shares worth a specific dollar amount.

Merger Model
45
 Medium

QUESTION 9

How do you account for transaction costs, financing fees,

and miscellaneous expenses in a merger model?

ANSWER 9

In the “old days,” you used to capitalize these expenses and then
amortize them; with new accounting rules introduced at the end of
2008, you’re supposed to expense transaction and miscellaneous
fees upfront but capitalize the financing fees and amortize them
over the life of the debt. Expensed transaction fees come out of
Retained Earnings when you adjust the Balance Sheet, while
capitalized financing fees appear as a new Asset on the Balance
Sheet and are amortized each year according to the tenor of the
debt.

Merger Model
46
 Medium

QUESTION 10

How do you handle options, convertible debt, and other

dilutive securities in a merger model?

ANSWER 10

The exact treatment depends on the terms of the Purchase

Agreement – the buyer might assume them or it might allow the
seller to “cash them out” assuming that the per-share purchase
price is above the exercise prices of these dilutive securities. If you
assume they’re exercised, then you calculate dilution to the equity
purchase price in the same way you normally would – Treasury
Stock Method for options, and assume that convertibles convert
into normal shares using the conversion price.

Merger Model
47
 Hard

QUESTION 11
How would an asset write-up or write-down affect an LBO
model? / Walk me through how you adjust the Balance Sheet
in an LBO model.
ANSWER 11
All of this is very similar to what you would see in a merger model –
you calculate Goodwill, Other Intangibles, and the rest of the write-
ups in the same way. Then the Balance Sheet adjustments (e.g.,
subtracting cash, adding in capitalized financing fees, writing up
assets, wiping out goodwill, adjusting the deferred tax
assets/liabilities, adding in new debt, etc.) are almost the same.
The key differences:
1. In an LBO model, you assume that the existing Shareholders’
Equity is wiped out and replaced by the equity the private
equity firm contributes to buy the company; you may also add in
Preferred Stock, Management Rollover, or Rollover from Option
Holders to this number as well depending on what you’re
assuming for transaction financing.
2. In an LBO model, you’ll usually add a lot more debt tranches
than you would see in a merger model.
3. In an LBO model, you’re not combining two companies’ Balance
Sheets.

Merger Model
48
 Hard

QUESTION 12
Why you would you use PIK (Payment In Kind) debt rather
than other types of debt, and how does it affect the debt
schedules and the other statements?

ANSWER 12
Unlike “normal” debt, a PIK loan does not require the borrower to
make cash interest payments – instead, the interest just accrues to
the loan principal, which keeps going up over time. A PIK “toggle”
allows the company to choose whether to pay the interest in cash
or have it accrue to the principal (these have disappeared since
the credit crunch). PIK is more risky than other forms of debt and
carries with it a higher interest rate than traditional bank debt or
high yield debt. Adding it to the debt schedules is similar to adding
high-yield debt with a bullet maturity – except instead of assuming
cash interest payments, you assume that the interest accrues to the
principal instead. You should then include this interest on the
Income Statement, but you need to add back any PIK interest on
the Cash Flow Statement because it’s a non-cash expense.

Merger Model
49
 Hard

QUESTION 13
How do you account for transaction costs, financing fees,
and miscellaneous expenses in a merger model?

ANSWER 13
In the “old days,” you used to capitalize these expenses and then
amortize them; with new accounting rules introduced at the end of
2008, you’re supposed to expense transaction and miscellaneous
fees upfront but capitalize the financing fees and amortize them
over the life of the debt. Expensed transaction fees come out of
Retained Earnings when you adjust the Balance Sheet, while
capitalized financing fees appear as a new Asset on the Balance
Sheet and are amortized each year according to the tenor of the
debt.

Merger Model
50
 Hard

QUESTION 14
How would I calculate “break-even synergies” in an M&A
deal and what does the number mean?

ANSWER 14
To do this, you would set the EPS accretion / dilution to $0.00 and
then back-solve in Excel to get the required synergies to make the
deal neutral to EPS. It’s important because you want an idea of
whether or not a deal “works” mathematically, and a high number
for the break-even synergies tells you that you’re going to need a
lot of cost savings or revenue synergies to make it work.

Merger Model
51
Stock

52
 Easy

QUESTION 1
What does it mean to short a stock?
ANSWER 1
Short selling is selling a stock that you don’t actually own. An
investor that short-sells a stock is taking the position that they will
be able to purchase that stock at a lower price in the future.
Normally a short-seller will borrow the stock from another investor,
and then sell it, promising to return the stock to the loaner at a later
date. “Naked” short selling occurs when an investor sells the stock
without having any of the stock actually borrowed.

Stock
53
 Medium

QUESTION 2
Why should a business think about issuing debt rather than
equity?

ANSWER 2
Opting for debt financing provides tax benefits since interest
payments can be deducted from taxes and allows for the retention
of ownership control, unlike equity, which dilutes shareholders'
authority. The fixed interest payments associated with debt offer
predictability, and for companies with stable cash flows, it can
potentially lower the weighted average cost of capital (WACC),
thus enhancing shareholder value. However, the choice must be
made while maintaining a balanced capital structure, as too much
debt can result in financial difficulties. Ultimately, the decision to
issue debt is warranted if it is in line with the company’s financial
strategy and growth objectives, all while minimizing expenses and
risks.

Stock
54
 Medium

QUESTION 3
If an option is “in the money” what does that mean?

ANSWER 3
An option is “in the money” when exercising the option will result in
a profit. A call option is in the money when its exercise price is
below the market price since an investor can purchase the asset at
the exercise price and instantly sell it at the market price. When an
option is "in the money" (ITM), it means that the current market
price of the underlying asset is such that exercising the option
would result in a profit for the option holder, essentially meaning
the strike price is favorable compared to the current market price;
for a call option, this means the stock price is above the strike
price, and for a put option, it means the stock price is below the
strike price.

Stock
55
 Medium

QUESTION 4
Xeron Software Corporation’s days sales outstanding have
gone from 58 days to 42 days. Does this make you more or
less likely to issue a Buy rating on the stock?

ANSWER 4
More likely. When the company’s days sales outstanding (DSOs)
decreases, it means the company is able to collect money from its
customers faster. In other words, Xeron’s customers went from
taking an average of 58 days to pay their bills to 42 days. All things
being equal, having faster paying customers is almost always a
good thing. Of course, one caveat is that you want to make sure
Xeron didn’t achieve this by imposing much tighter credit terms on
its customers and therefore. But if the company’s sales grew at the
same time its DSOs decreased, then as a research analyst or trader
you’ll be more likely to want to buy the stock.

Stock
56
 Hard

QUESTION 5
Would a seller prefer a stock purchase or an asset
purchase? What about the buyer?
ANSWER 5
A seller almost always prefers a stock purchase to avoid double
taxation and to get rid of all its liabilities. The buyer almost always
prefers an asset deal so it can be more careful about what it
acquires and to get the tax benefit from being able to deduct
depreciation and amortization of asset write-ups for tax purposes.

Stock
57
 Brain
Teasers

58
 QUESTION 1
You have a hose along with a 3 liter bucket and a 5 liter
bucket. How do you get exactly 4 liters of water?

ANSWER 1

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.

Brain Teasers
59
 QUESTION 2
Three envelopes are presented in front of you by an
interviewer. One contains a job offer, the other two contain
rejection letters. You pick one of the envelopes. The
interviewer then shows you the contents of one of the other
envelopes, which is a rejection letter. The interviewer now
gives you the opportunity to switch from the remaining two
envelope choices. Should you switch? (Monty Hall problem)

ANSWER 2
Yes. Say your original pick was envelope A. Originally, you had a
1/3 chance that envelope A contained the offer letter. There was a
2/3 chance that the offer letter was either in envelope B or C. If
you stick with envelope A, you still have the same 1/3 chance. Now,
the interviewer eliminated one of the envelopes (say, envelope B),
which contained a rejection letter. So, by switching to envelope C,
you now have a 2/3 chance of getting the offer and you’ve
doubled your chances.

Brain Teasers
60
 QUESTION 3
A car drives 60 miles at an average speed of 30 miles per
hour. How fast should the driver drive to travel the same 60
miles in the same time period, but at an average of 60 miles
per hour?

ANSWER 3

This is not possible. To travel 60 miles at an average speed of 30

miles per hour, 2 hours are required; to travel at an average of 60
miles per hour in those same 2 hours, you’d need to go 120 miles
rather than 60 miles. The most common mistake is to respond with
90 miles per hour or 120 miles per hour – if you get a question like
this in an interview, be sure to ask clarifying questions that could
point you in the right direction.

Brain Teasers
61
 QUESTION 4

There are 12 billard balls, one of them is either lighter or

heavier. How do you find the odd one by using a balance
scale only 3 times?

ANSWER 4

Let’s letter the balls from A-F.

First Weighing: Compare 4 balls (A-D) on the left with 4 balls
(E-H) on the right.
If balanced, the odd ball is among I, J, K, or L.
If unbalanced, the odd ball is in the heavier or lighter side
(A-H).
Second Weighing: Take 3 balls from the suspected group (e.g.,
IJK or CDE) and compare them with 3 known normal balls (e.g.,
ABC).
If balanced, the odd ball is the one left out (e.g., L or H).
If unbalanced, you narrow down the odd ball and whether
it’s heavier or lighter.
Third Weighing: Use two balls from the suspected group and
weigh them against each other (e.g., J vs. K or C vs. D).
If balanced, the odd ball is the one left out.
If unbalanced, you determine which ball is odd and its
weight difference.

Brain Teasers
62
 QUESTION 5

There is a casino where you can bet on a stock going up or

down every day. The stock is at $100 and either doubles in
price or goes down 50% every day. You have 4 options:
1. Bet on the stock going up.
2. Bet that it goes down.
3. Buy the stock.
4. Sell the stock.
Can you find a way to guarantee profit every day regardless
of whether the stock goes up or down?

ANSWER 5

To guarantee a profit regardless of the stock's movement, you

combine buying the stock with strategic betting. Purchase 1 share
of the stock at $100 and place two bets: $50 that the stock doubles
and $100 that it halves. If the stock doubles, its value becomes
$200, and you win $100 on the "up" bet but lose $100 on the
"down" bet, leaving you with $200. If the stock halves, its value
becomes $50, and you win $100 on the "down" bet but lose $50 on
the "up" bet, again totaling $200. This strategy ensures a net gain
of $100 regardless of whether the stock rises or falls.

Brain Teasers
63
References

64
 References

1. Technical Interview Guide; Preparation for Finance Interviews -

WallStreetOasis.com

2. The 400 Investment Banking Interview Questions & Answers You

Need to Know - Breaking into Wall Street

3.https://www.mygreatlearning.com/blog/finance-interview-
questions/

4.https://corporatefinanceinstitute.com/resources/career/real-
investment-banking-interview-questions-form/

5.https://mergersandinquisitions.com/investment-banking-
interview-questions-and-answers/

6. 50 Equity Research Analyst Questions with Answers

65