Recruiting Workshop Series Part II: Technical Workshop

Recapped by Daniel Novo

This week, WCM partnered with the Ivey Finance Club to provide first- and second-year students with a technical interview workshop, covering topics ranging from accounting to LBO questions. In this post, we’ll dive into some of the concepts covered in interviews with examples of common questions.

Accounting

Question Format: How changes to a certain aspect of a company’s operations affect the company’s financial statements.

The three main statements are the Income Statement (IS), Cash Flow Statement (CFS), and Balance Sheet (BS), which is also the order in which they connect.

How do the statements link?

• Net income from the IS flows into the CFS & Shareholders Equity on the BS
• Net change in cash from the CFS flows into cash on the BS
• Reflect changes in working capital (assets & liabilities) on the CFS

Question 1: You have an asset with a gross value of $1000 and a net book value of $400. You sell the asset for $600 cash. What happens to the 3 financial statements, assuming a 40% tax rate?

• Income Statement: Gain on Sale of $200, EBT is up $200, Tax -$80, NI up $120
• Cash Flow Statement: NI is up $120, Gain on sales is down $200 because it is a non-cash gain, CFFI is up $600, Net change in Cash is up $520.
• BS: Cash is up $520, PPE is down $400, Total Assets is up 120. RE is up $120, Total Liabilities & Equity is up $120, therefore it is balanced.

Operating Leverage Questions: Measure of the degree to which a firm can increase operating income by increasing revenue.

• High operating leverage means the majority of expenses are fixed while low operating leverage has a majority of expenses as variable.

Question 1: If a company’s revenue is expected to increase by $100, would you rather buy a company with higher operating leverage or lower?

• You’d choose the company with the high operating leverage because it implies a greater proportion of costs will be fixed, and therefore the increase in COGS accompanying the revenue increase will be lower.

Question 2: When would you rather invest in a company with lower operating leverage?

• You’d want to invest in a company with lower operating leverage when there is demand uncertainty and cyclicality. Important that the company has lower operating leverage so it can weather periods of lower revenue and reduce costs.

Question 3: An airline company has $3000 in revenue, $300 in variable costs, and $1000 in fixed costs. A trucking company has $3000 in revenue, $900 in variable costs and $400 in fixed costs. Which is riskier?

• Operating Leverage = Proportion Between Fixed and Variable Costs, and the higher the operating leverage, the riskier the company.
• In economic downturns, when revenue falls, a company continues paying significant fixed costs and operating leverage compresses more significantly.
• Therefore, the airline company is riskier.

DCF

There are three components of a DCF:

Projection Period:

• Projecting operational performance based on industry growth, management expectations, etc.
• Begin projections with revenue and use this to derive unlevered free cash flows
• Present value and sum cash flows from this period

Terminal Vale:

• Calculating discount rate (WACC)
• What is the present value of a company’s cash flows beyond the projection period?
• Gordon Growth Method takes a growth and discount rate into a formula and gives you the sum of the PV of FCF into perpetuity.
• Exit Multiple Method is to sell the company at a multiple of a financial metric such as EV/EBITDA that is based on things like industry standards.

Valuation and Implied Share Price

• The sum of the last two sections provide implied enterprise value
• This can then be converted to implied equity value, and finally implied share price
• Assess the implied upside or downside — is this company under or overvalued?

FIFO to LIFO

First-In, First Out: Assumes that the oldest products in a company’s inventory has been sold first and goes by those production costs.

Last-In, First Out: Assumes the most recent products in a company’s inventory have been sold first and uses those costs instead.

Question 1: A company switches its inventory management practices from FIFO to LIFO during an inflationary period. Based on this, can you explain how this impacts their DCF?

1. Projection Period: Old purchases were cheaper to produce, and the most recent purchase are more expensive, so given the switch, COGS rises since the recently purchased, more expensive inventory is being sold.
2. Terminal Value: Depends on which method is used (Gordon Growth vs. Exit Multiple) as impacts to EBITDA and free cash flows differ.
3. Free Cash Flows: COGS rises, work your way down to free cash flows, which rise as well.
4. Gordon Growth: Based on free cash flows, so valuation goes up.
5. Exit Multiple: Based on EBITDA, so valuation goes down.

Question 2: How Does an Increase in the Tax Rate Impact Valuation?

1. Free Cash Flows: A higher tax rate means lower NOPAT, and thus lower cash flows.
2. Cost of Debt: The cost of debt decreases as it’s protected by the “tax shield.”
3. Beta: Lower cost of equity from un-levering and re-levering, as it includes tax.

LBO

Leverage Buyouts are used by private equity firms. They purchase companies using investor capital and debt, make improvements over 5–10 years, and then sell them for a return

For example, let’s say we were to purchase Adil Inc. for $500k. In an LBO, we may use 100k of equity and 400k of debt to fund the transaction, the Debt to Equity split is 1:4. Now, we held the company for 5 years, and we sell it for $650k. We managed to pay off some debt during the holding period using the company’s FCF, and there’s now 200k debt remaining from the original 400k used. With the 650k proceeds from the sale, we pay off the remainder of the debt and are left with $450k in equity. Since we only used 100k of our own equity at purchase, we have a total return of 350% or 35% annually.

Two key metrics to evaluate an LBO are the Money-on-Money (MoM) multiple and Internal Rate of Return (IRR).

Question 1: Would you rather have a $5 increase in final year EBITDA or Free Cash Flows?

Under normal circumstances, you would immediately opt for free cash flow since EBITDA still has expenses and tax that need to be deducted. This question is not so simple though because it specifies the changes occur in the final year.

Cash Flow Component: “Cash is king” and the $5 increase in EBITDA ultimately impacts free cash flows by less than $5 due to tax and interest expenses which still need to be deducted.

Exit Component: If the company was going to be sold at a 10x multiple for example, the $5 increase in EBITDA also results in $50 extra proceeds from sale.

Question 2: Determine the IRR and MoM. Purchase Multiple: 10x, Max Debt: 7x, EBITDA: 100, Depreciation: $15, Tax Rate: 40%, Interest Rate: 5%, CapEx: $20, Holding Period: 5 Years, Exit Multiple: 11x.

1. Purchase Price: EBITDA * Purchase Multiple = 100 * 10x = $1,000
2. Debt to Equity Split: EBITDA * Max Debt = 100 * 7x = $700 Debt, therefore, $1,00 — $700 = $300 Equity.
3. EBITDA to Net Income: (EBITDA — Depreciation — Interest) * (1-TR) = [$100 — $15 — (5% * 700)] * (1–40%) = $30 Net Income.
4. Net Income to FCF: Net Income + Depreciation — CapEx = $30 + $15 — $20 = $25 Free Cash Flows.
5. Total Cash Inflows: (FCF * Holding Period) + (EBITDA * Exit Multiple) = ($25 * 5) + ($100 * 11x) = $1,225.
6. Net Free Cash Flows: Total Cash Inflows — Debt Repayment = $1,225 — $700 = $525.
7. Money-on-Money (MoM): Final Equity / Initial Equity Investment = $525 /$300 = $1.75x MoM.
8. Internal Rate of Return (IRR): 72 / Holding Period (Rule of 7) = 72 / 5 = 14.4% IRR.

Merger Model

Most common merger model questions for Banking interviews are Accretion/Dilution, and Theoretical and Accounting.

1. Accretion/Dilution = Test your understanding of merger models and key accretion/dilution concepts and calculations. Example: Is the deal accretive or dilutive? By what %?
2. Theoretical and Accounting: Test your understanding of reasons for acquisitions and key M&A accounting terms. Example: What are types of synergies and effects of acquisitions.

Question 1: Why Might an Acquirer Purchase Another Company?

• Financial Reasons: Consolidation/Economies of Scale, Gain Market Share, Seller is Undervalued, Acquire Customers, Product Expansion or Diversification.
• Fuzzy Reasons: Intellectual Property, Eliminate Competition, Hiring Talent, Management Ego and Pride, Publicity.

Question 2: Walk me through a Merger Model.

1. Project purchase price of the target.
2. Determine funds used (debt, equity, cash).
3. Project statements.
4. Determine the effects of acquisition.
5. Accretion/Dilution analysis.

Accretive: Increase in EPS following a merger or acquisition. The incremental growth of assets and earnings.

Dilutive: Decrease in EPS following a merger or acquisition. The incremental costs outweigh the incremental growth of assets and earnings.

Question 3: Company A has a 10x P/E multiple and Company B has a 20x P/E multiple. Company A acquires B. Is the deal accretive or dilutive?

First, determine the Weighted Average Cost of Capital and the Target’s Yield

• Cost of Cash = Foregone Interest on Cash * (1 — tax rate)
• Cost of Debt = Interest Rate * (1 — tax rate)
• Cost of Equity = Inverse of Buyer’s Yield (P/E multiple)
• If only given multiples, ask if its an ALL-STOCK deal
• Seller’s Yield = Inverse of Seller’s Yield (P/E multiple)

Second, compare the WACC with the Target’s Yield

• If Cost > Yield = Dilutive (EPS decreases)
• If Cost = Yield = Neither Accretive/Dilutive (EPS same)
• If Cost < Yield = Accretive (EPS increases)

Therefore, if this was an all-stock deal, the deal has a Cost of Equity of 10%, and a Seller’s Yield of 5%, making it dilutive.

Market-Based

Used to grasp a deeper Knowledge of finance, to showcase a passion for finance, and to demonstrate awareness of different economic factors.

Sample Questions:

• Thoughts on the economy?
• Tell me about an industry trend?
• Pitch me a stock/What’s a company you admire?
• Short me a stock.
• What’s an M&A transaction you are following?
• Which two companies should merge?

How to Answer these?

Provide a 60-second answer that covers:

• Event/company summary (business models, market characteristics).
• Primary thesis point (Why this stock? Why this outcome?).
• 1–2 catalysts to your point.

Helpful Resources:

Morning Brew: https://www.morningbrew.com/

FT Due Diligence: https://www.ft.com/due-diligence

Axios: https://www.axios.com/

RBC Investment Outlook: https://www.rbcgam.com/en/ca/insights/global-investment-outlook

More: https://www.westerncapitalmarkets.com/resources

Other Considerations

Preparation:

• The value is in the explanation, not the answer. Work through the steps rather than focusing on the answer.
• If stuck, draw on your existing understanding of concepts and work your way to a potential answer.
• Structure is your friend — identify if you’re giving too much or not enough info.

Delivery:

• Keep composed, clarify questions if needed, and write down information
• Enunciate!
• Speak slower than you think you need to!
• Talk through every step — even if you’re stuck.
• Be conversational and fake it ’til you make it!

Key Takeaways:

1. Make the most of your available time and familiarize yourself with the basics
2. Structure and practice are your best friends
3. Keep up to date with market news
4. Stay confident and keep calm! Show your work!

Remember that technical questions can lose you the job opportunity, but they can’t get you the job. They are qualifying questions rather than selective criteria for interviews. Behavioural questions are the differentiating factors