Investment Banking

Technical Interview
Questions
Q. What does the discount rate (WACC)
represent?

The discount rate in a DCF model adjusts the value of future

cash flows downward because of the time value of money, i.e.
a dollar today is worth more than a dollar received in the
future.

More specifically, the discounted rate – or WACC in an

unlevered DCF – represents the expected return on investment
given its risk profile.

Therefore, the discount rate is a function of the riskiness of the

cash flows since potential returns and risk go hand in hand.

In practice, the discount rate is the minimum return threshold

(i.e. the hurdle rate) of an investment based on comparable
investments with similar risks.

Higher Discount Rate → A higher discount rate makes a

company’s cash flows LESS valuable since it implies there is
MORE risk.

Lower Discount Rate → A lower discount rate causes a

company’s future cash flows to be MORE valuable because
there is LESS risk.
Q. What is the formula to calculate the
weighted average cost of capital (WACC)?
The weighted average cost of capital (WACC) is the
opportunity cost of an investment based on comparable
investments of similar risk/return profiles.

Calculating the WACC involves multiplying the equity weight

(%) by the cost of equity and then adding it to the debt weight
(%) multiplied by the after-tax cost of debt.

The cost of debt must be tax-effected since interest is tax-

deductible.

The market values of equity and debt should be used, not the
book values from the balance sheet – but in practice, the
market value of debt rarely deviates far from the book value.

WACC Formula

WACC = [Ke * (E / (D + E)] + [Kd * (D / (D + E)]

Where:

E / (D + E) = Equity Weight %
D / (D + E) = Debt Weight %
Ke = Cost of Equity
Kd = After-Tax Cost of Debt
Q. Explain the concept of beta (β).

Beta measures the systematic risk of a security compared to

the broader market, i.e. the non-diversifiable risk which
cannot be reduced from portfolio diversification.

For example, a company with a beta of 1.0 would expect to

see returns consistent with the overall stock market returns
(S&P 500).

So, if the market increased by 10%, the company should

expect to see a return of 10%.

But suppose a company has a beta of 2.0 instead; the

expected return in such a case would be 20% if the market
had gone up by 10%

Beta/Market Sensitivity Relationship

β = 0 → No Market Sensitivity
β < 1 → Low Market Sensitivity
β > 1 → High Market Sensitivity
β < 0 → Negative Market Sensitivity
 Q. Walk me through a DCF model.
The most common valuation method is DCF which is built using the following
steps:

Step 1: Forecast Free Cash Flow to Firm (FCFF): In the first step, the FCFFs of the
company are projected for a five to ten-year time span.

Step 2: Calculate Terminal Value (TV): In the next step, the value of all the
projected FCFs beyond the initial forecast period (i.e. the explicit forecast period)
is calculated, and the resulting amount is called the “terminal value”. The two
approaches for estimating TV is the 1) Growth in Perpetuity Approach and the 2)
Exit Multiple Approach.

Step 3: Discount Stage 1 and 2 Cash Flows to Present Value (PV): Since the DCF
values a company as of the present date, both the initial forecast period (Stage 1)
and terminal value (Stage 2) must be discounted to the present using a discount
rate, which is the weighted average cost of capital (WACC) in an unlevered DCF.

Step 4: Move from Enterprise Value (TEV) → Equity Value: Once both parts have
been discounted, the sum of both stages equals the implied enterprise value of the
company. Then, to get from the enterprise value to the equity value, net debt and
other non-equity claims must be subtracted. In order to calculate net debt, the
sum of all non-operating assets such as cash or short-term investments is
subtracted from the total value of debt. In addition, any non-equity claims such as
minority interest must also be accounted for.

Step 5: Implied Share Price Calculation: To arrive at the DCF-derived value per
share, the equity value is then divided by the number of shares outstanding as of
the current valuation date. But it is important to use the diluted share count, rather
than the basic share count, as any potentially dilutive securities must be
considered.

Step 6: Sensitivity Analysis: Considering how sensitive a DCF model is to the

assumptions used, the final step is to create sensitivity tables (and a scenario
analysis) to assess how adjusting the assumptions impacts the resulting price per
share.
Q. What is the difference between the
unlevered DCF and the levered DCF?

Unlevered DCF:
Under the unlevered DCF approach, the unlevered FCFs are
the appropriate cash flows to forecast and the correct
discount rate is the WACC, which reflects the riskiness to
both debt and equity capital providers. The resulting value
arrived at is enterprise value, which must be adjusted for net
debt and non-equity interests to calculate the equity value.

Levered DCF:
The levered DCF approach projects FCFE and the appropriate
discount rate is the cost of equity since FCFE belongs to only
equity holders. Moreover, the levered DCF approach arrives
at equity value directly. To calculate the enterprise value, the
net debt must be added back, along with adjusting for non-
equity claims.

In theory, the levered and unlevered DCF approach should

calculate the same enterprise value and equity value, yet the
two are rarely precisely equivalent.
Q. When would a DCF be an inappropriate
valuation method?

Limited Financials:
If access to a company’s financial statements is limited, the
DCF approach is more difficult and a comps analysis would
typically be the better option. Even with limited financial data,
a comps analysis can still be performed, but a DCF model
requires numerous assumptions that are directly based on
historical financials, internal data, management commentary,
etc.

Unprofitable Start-Ups:
DCFs can also be unfeasible for companies not expected to
turn a profit (i.e. break even) for the foreseeable future, such
as a pre-revenue start-up. Since such a substantial portion of
the company’s value is weighted towards the future, the DCF
loses credibility in these cases. For the DCF to be somewhat
“credible” for a start-up, there must be at least a path towards
becoming cash flow positive in the future. Even so, the
accuracy of such a forecast is highly questionable, and the
implied value will not hold much weight.

The DCF method is most credible for mature companies with

an established market position, business model, and market
positioning, which have a historical track record (and years of
financial reports) on which the model assumptions are based
upon.
Q. Is the cost of debt or the cost of equity
typically higher?

The cost of equity is typically higher than the cost of debt – at

least initially.

Interest Tax Shield: The cost associated with borrowing debt

(i.e. the interest expense) is tax-deductible, which creates a
“tax shield” that reduces a company’s pre-tax income. In
comparison, dividends are not tax-deductible.

Priority of Claims: The cost of equity is also higher because

equity investors are not guaranteed fixed interest payments
and are last in line in the capital structure (i.e. they are lowest
in the priority of recovery in the event of a forced liquidation).
Q. If the cost of equity is higher than the
cost of debt, why not finance using entirely
debt?

While it is true that the cost of debt is lower than the cost of
equity, the benefits of debt capital tend to wane at a certain
point where the risk of default and bankruptcy outweigh the
benefits.

The “optimal” capital structure for the majority of companies

should include a mixture of debt and equity.

Initially, as the proportion of debt in a company’s capital

structure increases, WACC declines from the tax-deductibility
of interest.

But once more debt is incrementally added to the capital

structure – beyond a certain point – the risk to all company
stakeholders increases (i.e. the WACC) because a highly
levered company has a greater risk of default.

Eventually, the default risk offsets the tax advantages of debt,

and the WACC soon reverses course as the risk to all debt
and equity stakeholders increases.
Q. What are the two methods to calculate
the terminal value (TV)?
There are two common approaches for calculating the
terminal value (TV).

1. Growth in Perpetuity Approach:

The growth in perpetuity approach, or “Gordon Growth
method”, calculates the TV by assuming a perpetual growth
rate on cash flows after the explicit forecast period and then
inserting this assumption into the static perpetuity formula.
The long-term growth rate is the sustainable rate at which the
company grows into perpetuity and typically ranges from 1%
to 3% (in line with expected inflation).

Perpetuity Approach Formula

Terminal Value = [Final Year FCF * (1 + Perpetuity Growth

Rate)] / (Discount Rate – Perpetuity Growth Rate)

2. Exit Multiple Approach: The exit multiple approach

calculates the terminal value by applying a multiple
assumption on a financial metric (usually EBITDA) in the
terminal year. The peer-derived multiple should reflect the
multiple of a comparable company in a mature state.

Exit Multiple Approach

Terminal Value = Final Year EBITDA * Exit Multiple

Q. What are some of the most common
margins used to measure profitability?

Gross Margin: The percentage of revenue remaining after

subtracting the company’s direct costs (COGS).

Gross Margin = (Revenue – COGS) / (Revenue)

Operating Margin: The percentage of revenue remaining after

subtracting operating expenses such as SG&A from gross
profit.

Operating Margin = (Gross Profit – OpEx) / (Revenue)

EBITDA Margin: The most commonly used margin is due to its

usefulness in comparing companies with different capital
structures (i.e. interest) and tax jurisdictions.

EBITDA Margin = (EBIT + D&A) / (Revenue)

Net Profit Margin: The percentage of revenue remaining after

accounting for all of the company’s expenses. Unlike other
margins, taxes and capital structure have an impact on the
net profit margin.

Net Margin = (EBT – Taxes) / (Revenue)

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