Core Concepts Interview Questions

What does the "Discount Rate" mean?

Your opportunity cost, or targeted yield: what you could earn on other, similar investments. It reflects both the potential returns and the risk of those alternatives. A higher discount rate means higher returns and higher risk, and it lowers present value.

You estimate that a company's WACC is 8.0%. What does that mean?

If you invested proportionally in both the company's equity and its debt, you would expect to earn about 8% per year on average over the long term. It is the blended return its capital providers require and the standard discount rate for valuing the company. Single years vary; WACC is the long-term average.

How much would you pay for a company that generates $100 of cash flow every single year into eternity?

It depends on the discount rate. No growth: Value = Cash Flow / Discount Rate. At 10%: $100 / 10% = $1,000. At 20%: $100 / 20% = $500. With growth: Value = Cash Flow / (Discount Rate - Growth Rate), where growth < discount rate.

How do you decide whether or not to invest in a company or asset?

Invest when (1) the asking price is below intrinsic value (positive NPV) and (2) the potential return exceeds your opportunity cost (IRR > discount rate). The numbers are a rule of thumb; also check qualitative and market factors.

What does the internal rate of return (IRR) mean?

The effective compounded annual return on an investment. It is also the discount rate at which NPV = 0. Example: $1,000 growing to $2,000 in 5 years gives (2,000 / 1,000)^(1/5) - 1 = 14.87%. If IRR > discount rate or WACC, it makes sense to invest.

Wait, what's "Net Present Value"?

NPV = present value of an investment's cash flows (the sum of its discounted cash flows) minus the asking price paid upfront. Example: PV of $1,000 - price of $800 = NPV of $200. Positive NPV means it is worth more than it costs; NPV = 0 at the IRR.

What would make the IRR increase or decrease?

IRR increases if expected cash flows rise, cash flows grow faster, the expected selling price rises, or the asking price falls. It decreases in the opposite cases. The discount rate does NOT affect IRR because IRR solves for the discount rate.