INTERVIEW QUESTIONS: Morgan Stanley, investment banking division (IBD), internship

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Question

Tell me how would you valuate a company? Which are the most used financial tools in this area?

Answer given:

When we are acquiring a company, we are buying its stock (equity) and assuming its debt (loans and bonds). The value of debt is not difficult to calculate because we can use the book value of debt. However, the market value of equity is not so easy and we need to use different valuation techniques. The most commonly used techniques to determine the market value of equity are: discounted cash flow (DCF) analysis, multiples method and comparable transactions method.

Question

Why cannot we use EV/Earnings or Price/EBITDA as valuation metrics?

Answer given: 

Enterprise Value (EV) equals the value of the operations of the company from all providers of capital. Therefore, as EV incorporates all of both debt and equity, it is not dependant on the choice of capital structure. If we use EV in the numerator of our valuation metric, to be consistent we must use an operating or capital structure neutral (unlevered) metric in the denominator, such as Sales, EBIT or EBITDA. These such metrics are also not dependant on capital structure because they do not include interest expense. Operating metrics such as earnings do include interest and so are considered leveraged or capital structure dependant metrics. Therefore EV/Earnings is an apples to oranges comparison and is considered inconsistent. Similarly Price/EBITDA is inconsistent because Price (or equity value) is dependant on capital structure (levered) while EBITDA is unlevered. Again, apples to oranges. Price/Earnings is fine (apples to apples) because they are both levered.

Question

What factors can lead to the dilution of EPS in an acquisition?

Answer given:

A number of factors can cause an acquisition to be dilutive to the acquiror’s earnings per share (EPS), including: (1) the target has negative net income, (2) the target’s Price/Earnings ratio is greater than the acquiror’s, (3) the transaction creates a significant amount of intangible assets that must be amortized going forward, (4) increased interest expense due to new debt used to finance the transaction, (5) decreased interest income due to less cash on the balance sheet if cash is used to finance the transaction and (6) low or negative synergies.

Question 

Why do we subtract cash in the enterprise value formula?

Answer given:

Cash gets subtracted when calculating Enterprise Value because (1) cash is considered a non-operating asset AND (2) cash is already implicitly accounted for within equity value. It is important to remark that when we subtract cash, to be precise, we should say excess cash. However, we will typically make the assumption that a company’s cash balance (including cash equivalents such as marketable securities or short-term investments) equals excess cash.

We cannot guarantee the authenticity of these questions nor the accuracy of the answers: they are what one candidate claims to have been asked by Morgan Stanley and have not been verified by the bank.

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