Investment Banking Technical Questions

• What does the discount rate in a DCF model do to future cash flows?

  It adjusts the value of future cash flows downward.
• Why is a dollar today worth more than a dollar received in the future?

  Because of the time value of money.
• What does WACC stand for in an unlevered DCF?

  Weighted Average Cost of Capital.
• What does the discount rate represent in terms of investment?

  It represents the expected return on investment given its risk profile.
• How is the discount rate related to the riskiness of cash flows?

  The discount rate is a function of the riskiness of the cash flows.
• What is the minimum return threshold of an investment called?

  It is called the hurdle rate.
• How does a higher discount rate affect a company's cash flows?

  • A higher discount rate makes a company’s cash flows LESS valuable.
  • It implies there is MORE risk associated with the cash flows.
• How does a lower discount rate affect a company's future cash flows?

  • A lower discount rate causes a company’s future cash flows to be MORE valuable.
  • It indicates there is LESS risk associated with the cash flows.
• What does WACC stand for?

  Weighted Average Cost of Capital
• What is the WACC based on?

  The opportunity cost of an investment based on comparable investments of similar risk/return profiles
• How do you calculate WACC?

  By multiplying the equity weight by the cost of equity and adding it to the debt weight multiplied by the after-tax cost of debt
• Why must the cost of debt be tax-effected?

  Because interest is tax-deductible
• What values should be used to calculate WACC?

  The market values of equity and debt
• How does the market value of debt typically compare to its book value?

  The market value of debt rarely deviates far from the book value
• What is the WACC formula?

  WACC = $[K_e * (E / (D + E))] +$$[K_d * (D / (D + E))]$

  Where:

  • $E / (D + E)$ = Equity Weight %
  • $D / (D + E)$ = Debt Weight %
  • $K_e$ = Cost of Equity
  • $K_d$ = After-Tax Cost of Debt
• What does beta measure in finance?

  Beta measures the systematic risk of a security compared to the broader market.
• What type of risk does beta represent?

  Beta represents non-diversifiable risk which cannot be reduced from portfolio diversification.
• If a company has a beta of 1.0, what is the expected return if the market increases by 10%?

  The expected return would be 10%.
• What would be the expected return for a company with a beta of 2.0 if the market increased by 10%?

  The expected return would be 20%.
• What is the relationship between beta values and market sensitivity?

  • β = 0 → No Market Sensitivity
  • β < 1 → Low Market Sensitivity
  • β > 1 → High Market Sensitivity
  • β < 0 → Negative Market Sensitivity