Question 1

What key criteria distinguish NPV from IRR in evaluating capital projects?

Accepted Answer

The key criteria that distinguish NPV from IRR are that NPV measures the absolute value added by a project, while IRR indicates the rate of return at which NPV equals zero. NPV is more reliable for comparing projects of different scales, whereas IRR can be misleading if cash flows are non-conventional.

Question 2

Why is NPV generally considered superior to IRR when deciding between mutually exclusive projects?

Accepted Answer

NPV is generally considered superior to IRR for mutually exclusive projects because it provides a direct measure of the expected increase in value from a project. NPV accounts for the scale of investment and the time value of money, while IRR can be misleading, especially when cash flows are non-conventional or when comparing projects of different sizes.

Question 3

How would you handle multiple IRRs when a project has non‑conventional cash flows?

Accepted Answer

I would analyze the cash flow pattern to determine the most relevant IRR, consider using the Modified Internal Rate of Return (MIRR) for a clearer assessment, and evaluate the project's net present value (NPV) at different discount rates to guide decision-making.

Question 4

What are the limitations of using IRR in capital budgeting?

Accepted Answer

The IRR method can present multiple IRRs for projects with non-conventional cash flows, making it ambiguous. Additionally, it assumes that cash inflows are reinvested at the same rate as the IRR, which may not be realistic. This can lead to misinterpretation of a project's profitability.

Question 5

Describe a scenario where IRR would be misleading due to scale or timing differences.

Accepted Answer

A scenario where IRR could be misleading is when comparing two projects of different scales. For instance, a small project with a high IRR might generate less overall profit than a larger project with a lower IRR. Additionally, if the cash flows of a project are received earlier, it may show a higher IRR, even if the total returns are lower than a project with delayed cash flows.

Question 6

How do you incorporate working capital changes into NPV calculations?

Accepted Answer

Working capital changes are incorporated into NPV calculations by adjusting the cash flows for the increase or decrease in current assets and liabilities. An increase in working capital represents a cash outflow, while a decrease represents a cash inflow, both of which must be factored into the overall cash flow projections for the investment.

Question 7

What impact does the discount rate have on the ranking of two competing projects with different cash flow timings?

Accepted Answer

The discount rate affects the present value of future cash flows. A higher discount rate reduces the present value of cash flows, which can alter the ranking of projects. If one project has earlier cash flows, it may be favored over another with later cash flows, assuming the same initial investment and total cash flows.

Question 8

How do you compute adjusted present value (APV) and when is it preferred over WACC‑based NPV?

Accepted Answer

Adjusted Present Value (APV) is computed by determining the NPV of a project assuming it is all-equity financed and then adding the present value of the tax shield from debt. It is preferred over WACC-based NPV in situations where the financing structure is complex or when the benefits of debt change significantly over time.

Question 9

How would you reflect inflation (real vs nominal) in your NPV calculation?

Accepted Answer

To reflect inflation in NPV calculations, I would use nominal cash flows and a nominal discount rate, ensuring consistency. Alternatively, if using real cash flows, I would apply a real discount rate to account for inflation, which allows for accurate comparison of investment value over time.

Question 10

How do you adjust project cash flows for differential taxes or subsidies in NPV analysis?

Accepted Answer

To adjust project cash flows for differential taxes, I first calculate the after-tax cash flows by applying the tax rate to the pre-tax cash flows. For subsidies, I include them as cash inflows in the cash flow projections. This ensures that the NPV reflects the true economic benefit of the project.

Question 11

What is the crossover rate when comparing two projects with different rate sensitivities?

Accepted Answer

The crossover rate is the discount rate at which the net present values of two projects are equal. To find it, I analyze the cash flows of both projects and calculate their NPV at various discount rates. This helps in determining the rate at which the preference between the two projects changes based on their sensitivities to rate fluctuations.

Question 12

How do you treat mid‑year cash flows or half‑year conventions in NPV or IRR?

Accepted Answer

Mid-year cash flows can be adjusted in NPV and IRR calculations by discounting them using a half-year convention, which provides a more accurate representation of the timing and value of cash flows compared to annualizing them.

Question 13

How should sunk costs, incremental costs, and opportunity costs be treated in NPV/IRR analysis?

Accepted Answer

In NPV/IRR analysis, sunk costs should be ignored as they are past expenses that cannot be recovered and do not affect future cash flows. Incremental costs, which are the additional costs incurred due to the project, must be included in the analysis to assess the project's true profitability. Additionally, opportunity costs should be considered, as they represent the potential benefits lost from not pursuing the next best alternative investment.

Question 14

Describe how real options (e.g., expansion, abandonment) impact capital budgeting via option‑adjusted NPV.

Accepted Answer

Real options provide the flexibility to adapt investment decisions based on changing market conditions. By incorporating option-adjusted NPV, we can quantify the value of potential future decisions, such as expansion or abandonment, which enhances capital budgeting by reflecting the strategic value of options that traditional NPV calculations might overlook.

Question 15

How would you evaluate a project with a salvage value convertible to a perpetuity?

Accepted Answer

To evaluate such a project, I would calculate the present value of the expected cash flows from the project and add the present value of the salvage value treated as a perpetuity, which is calculated by dividing the salvage value by the discount rate.

Question 16

How do you compute the cost of equity using CAPM, and what are the core assumptions?

Accepted Answer

The cost of equity can be computed using the Capital Asset Pricing Model (CAPM) formula: Cost of Equity = Risk-free rate + Beta * (Market return - Risk-free rate). The core assumptions include that investors hold diversified portfolios, markets are efficient, and that the risk is measured by Beta.

Question 17

What are alternate models to CAPM, such as the dividend discount model (DDM) or multifactor models?

Accepted Answer

Alternate models to CAPM include the Dividend Discount Model (DDM), which values a stock based on its expected future dividends, and multifactor models, which incorporate multiple variables beyond market risk to explain asset returns, providing a more nuanced view of risk and return.

Question 18

How do you estimate the cost of debt, including current yield or yield to maturity?

Accepted Answer

To estimate the cost of debt, I would consider both the current yield and yield to maturity. The current yield is calculated by dividing the annual interest payment by the market price of the bond, while the yield to maturity incorporates the total returns over the life of the bond, reflecting the bond's current market price, coupon payments, and time to maturity. Both metrics provide insight into the effective cost of borrowing.

Question 19

How is the weighted average cost of capital (WACC) calculated and what market values should be used?

Accepted Answer

WACC is calculated using the formula: WACC = (E/V * Re) + (D/V * Rd * (1-T)), where E is the market value of equity, D is the market value of debt, V is the total market value of the firm, Re is the cost of equity, Rd is the cost of debt, and T is the tax rate. Market values should reflect current trading prices for equity and the book value of debt adjusted for market conditions.

Question 20

How do you adjust WACC for project‑specific risk or different business risk profiles?

Accepted Answer

To adjust WACC for project-specific risk, I would first assess the risk profile of the project compared to the company's overall risk. This could involve adjusting the cost of equity by using a higher beta that reflects the project's risk or incorporating a risk premium into the cost of debt. Additionally, I would consider adjusting the capital structure weights if the project requires different financing terms, ensuring the WACC accurately reflects the specific risks associated with the project.

Question 21

When is unlevered cost of equity used, and how is it computed?

Accepted Answer

Unlevered cost of equity is used when analyzing a company's performance without the effects of debt, often computed using the Capital Asset Pricing Model (CAPM) by adjusting the risk-free rate and equity beta for an all-equity firm.

Question 22

How does financial distress risk affect WACC and hence project valuation?

Accepted Answer

Financial distress risk increases the cost of equity due to higher required returns from investors and raises the cost of debt as lenders demand a risk premium. This elevated WACC leads to lower project valuations, as the discount rate applied to future cash flows becomes higher, reflecting the increased risk.

Question 23

How would you estimate the cost of preferred equity or hybrid instruments?

Accepted Answer

To estimate the cost of preferred equity or hybrid instruments, I would calculate the dividend yield based on the expected dividends, add a risk premium reflecting the credit risk and market conditions, and consider the overall cost of capital to ensure a comprehensive assessment.

Question 24

Describe how taxes affect WACC and project valuation.

Accepted Answer

Taxes affect WACC by creating a tax shield on debt, which lowers the effective cost of capital. Additionally, changes in tax rates can impact the cost of equity, thereby influencing the overall WACC. This, in turn, affects project valuation as cash flows are discounted at this rate.

Question 25

How do you compute project‑specific WACC if the project has a different risk profile than the parent?

Accepted Answer

To compute project-specific WACC, I would first determine the cost of equity using the Capital Asset Pricing Model (CAPM), adjusting for the project's risk premium. Next, I would calculate the after-tax cost of debt, considering the project's specific borrowing terms, and finally, weigh these costs based on the project's capital structure to derive the WACC.

Question 26

What are the theoretical foundations of optimal capital structure—MM propositions, trade‑off theory, pecking order, agency theory?

Accepted Answer

The Modigliani-Miller (MM) propositions assert that in a perfect market, capital structure does not affect firm value. The trade-off theory balances the tax advantages of debt against bankruptcy costs, while the pecking order theory suggests firms prefer internal financing over external. Agency theory addresses conflicts between stakeholders, impacting financing decisions.

Question 27

How do tax shields from debt influence firm value and capital structure decisions?

Accepted Answer

Tax shields from debt arise because interest payments are tax-deductible, which effectively reduces the overall tax burden of a firm. This can enhance firm value by increasing cash flow and providing a tax advantage. When making capital structure decisions, firms may opt for higher leverage to take advantage of these tax benefits, balancing the increased risk of bankruptcy against the cost of equity.

Question 28

What factors would lead a firm to deviate from its target debt ratio temporarily?

Accepted Answer

A firm may temporarily deviate from its target debt ratio due to adverse market conditions affecting revenue, unexpected cash flow challenges, or the need to finance strategic investments that require immediate capital.

Question 29

How do financial covenants or credit rating targets impact capital structure strategy?

Accepted Answer

Financial covenants and credit rating targets significantly influence a company's capital structure strategy by imposing limits on leverage and dictating acceptable debt levels. Meeting these requirements is crucial for maintaining favorable credit terms, which in turn affects funding options and overall financial flexibility.

Question 30

How would you evaluate the use of operating versus financial leases in the context of leverage?

Accepted Answer

Operating leases are typically off-balance sheet and do not increase reported debt, thus keeping leverage ratios lower. Financial leases, however, are capitalized on the balance sheet, increasing both assets and liabilities, which can affect leverage ratios and financial analysis.

Question 31

What is the effect of leverage on earnings per share (EPS) volatility and return on equity (ROE)?

Accepted Answer

Leverage can amplify earnings per share (EPS) volatility because fixed interest expenses must be paid regardless of revenue fluctuations, increasing risk during downturns. However, when used effectively, leverage can enhance return on equity (ROE) by enabling a company to invest in growth opportunities that yield higher returns than the cost of debt.

Question 32

How does CAPM risk adjust for equity and debt proportions when re‑levering beta?

Accepted Answer

CAPM risk adjusts for equity and debt proportions by re-levering beta to reflect the new capital structure. The formula involves adjusting the levered beta based on the debt-to-equity ratio, thus accounting for the risk associated with the increased financial leverage. This helps in accurately assessing the expected return on equity considering the firm’s risk profile.

Question 33

How would a firm determine its optimal mix of debt, equity, and hybrid instruments?

Accepted Answer

A firm determines its optimal mix by analyzing the cost of capital for each financing option, assessing the associated risks, and considering current market conditions and the firm's growth strategy to achieve a balance that minimizes the overall cost of capital.

Question 34

What is the impact of inflation or changing interest rates on optimal leverage decisions?

Accepted Answer

Inflation typically erodes the real value of debt, making it cheaper over time, which may encourage higher leverage. Conversely, rising interest rates increase borrowing costs, prompting firms to reassess optimal leverage levels. A balance must be struck to maximize returns while managing financial risk.

Question 35

How can one use adjusted present value (APV) when capital structure varies over a project’s life?

Accepted Answer

Adjusted Present Value (APV) can be used by first valuing the project as if it were all-equity financed, then adding the present value of financing effects, such as tax shields, while adjusting for changes in capital structure over the project's life to reflect varying risk profiles.

Question 36

What are the main theories of dividend policy—residual theory, bird‑in‑hand, signaling, clientele effects?

Accepted Answer

The main theories of dividend policy include the residual theory, which suggests dividends should be paid from leftover earnings after all profitable investments are made; the bird-in-hand theory, which posits that investors prefer certain dividends over uncertain future capital gains; the signaling theory, where dividends signal management's confidence in future earnings; and the clientele effects, where different investor groups prefer different dividend policies based on their tax situations.

Question 37

How does a firm balance dividend payouts against internal investment needs in capital budgeting?

Accepted Answer

A firm balances dividend payouts against internal investment needs by analyzing its cash flow projections and determining the optimal capital structure. It must assess the return on investment for internal projects against the expected returns from distributing dividends to shareholders. By prioritizing projects that align with long-term strategic goals while ensuring sufficient liquidity for dividends, firms can maintain investor confidence and support growth.

Question 38

What are the tax implications of different dividend policies for shareholders?

Accepted Answer

Different dividend policies can significantly impact shareholders' tax implications. For instance, cash dividends are typically taxed as ordinary income, while qualified dividends may be taxed at a lower capital gains rate. Retained earnings may enhance company growth, indirectly benefiting shareholders through increased stock value, but without immediate tax implications.

Question 39

How does share repurchase compare to dividends as a method of returning cash to shareholders?

Accepted Answer

Share repurchase can enhance shareholder value by reducing the number of shares outstanding, thus increasing earnings per share, while also providing tax advantages over dividends. Unlike dividends, repurchases offer flexibility as companies can adjust the amount based on cash flow availability.

Question 40

Under what scenarios would a stable dividend policy be preferred over a residual or targeted payout ratio?

Accepted Answer

A stable dividend policy is preferred when a company has predictable earnings, as it provides consistency and reassurance to investors. It is also favored when investors have a preference for regular income and when market conditions are stable, allowing for sustained dividend payments without jeopardizing reinvestment opportunities.

Question 41

A company launches a new project with high variability in cash flows—how would real options analysis shape investment decisions beyond NPV/IRR?

Accepted Answer

Real options analysis allows companies to evaluate the flexibility and strategic value of investment decisions under uncertainty. Unlike traditional NPV/IRR methods, it accounts for the ability to adapt or modify projects in response to changing market conditions, thereby providing a more comprehensive framework for assessing potential risks and rewards.

Question 42

How do you assess a leveraged buyout’s feasibility using NPV and APV frameworks?

Accepted Answer

To assess a leveraged buyout’s feasibility, I analyze the projected cash flows and discount them to present value using the NPV framework. I also use the APV method to separate the value of the firm’s operations from the effects of financing, allowing for a clearer understanding of the risk and return profile associated with the leverage.

Question 43

Given a multinational with access to different markets, how would you estimate a project‑specific discount rate for WACC?

Accepted Answer

To estimate a project-specific discount rate for WACC, I would assess the market risk associated with the specific project, incorporate a country risk premium reflecting the economic stability of the market, and analyze the capital structure to determine the appropriate weights for equity and debt.

Question 44

A firm pursues a merger funded partly by equity—how does this affect its WACC and NPV of combined operations?

Accepted Answer

Funding a merger partly through equity can lower the firm's Weighted Average Cost of Capital (WACC) since equity is generally less expensive than debt in terms of risk. A lower WACC increases the Net Present Value (NPV) of the combined operations, making the merger more attractive as it enhances the potential for value creation.

Question 45

How would you recommend modifying dividend policy after securing high‑return projects with limited internal funds?

Accepted Answer

I would recommend a careful assessment of cash flow projections to determine the sustainability of dividends. If high-return projects are prioritized, I would suggest a temporary reduction in dividends while clearly communicating this strategy to stakeholders to emphasize long-term value creation.

Question 46

A firm faces credit rating pressure—what capital structure and cost of capital adjustments would you advise?

Accepted Answer

I would recommend adjusting the capital structure by reducing the debt-to-equity ratio to enhance creditworthiness, potentially refinancing existing debt to lower the cost of capital, and exploring equity financing options to improve liquidity and investor confidence.

Question 47

How can sensitivity or scenario analysis enhance the robustness of NPV/IRR decisions under cost of capital uncertainty?

Accepted Answer

Sensitivity and scenario analysis allow decision-makers to evaluate how changes in key assumptions, such as cash flows and cost of capital, impact NPV and IRR. This enhances robustness by identifying potential risks and informing better investment strategies.

Question 48

What are the treasury implications of a zero‑debt versus high‑leverage capital structure on cash management?

Accepted Answer

A zero-debt capital structure typically results in lower risk and more stable cash flows, allowing for greater liquidity and flexibility in cash management. In contrast, a high-leverage structure can increase cash flow volatility due to interest obligations, necessitating more rigorous cash forecasting and management to ensure sufficient liquidity for debt servicing.

Question 49

How would you reconcile differences between project IRR hurdle rates and overall WACC in decentralized divisions?

Accepted Answer

To reconcile differences between project IRR hurdle rates and overall WACC, I would first assess the risk profile of each project, as decentralized divisions may have varying risk factors. Then, I would adjust the hurdle rates to reflect these risks and ensure alignment with the overall cost of capital. This involves thorough analysis and communication with division heads to establish a consistent evaluation framework.

Question 50

A company is considering a new project denominated in foreign currency—how would you factor financing cost, FX risk, and capital structure in its valuation?

Accepted Answer

In valuing the project, I would first assess the financing cost by considering the local interest rates and the impact of currency fluctuations on debt servicing. I would incorporate FX risk by evaluating potential hedging strategies, such as forward contracts or options. Additionally, the capital structure should be optimized to balance debt and equity, ensuring that the cost of capital reflects the project's risk profile.

Capital Budgeting & Cost of Capital – Interview Q&A

A. Investment Appraisal – NPV & IRR

Q1: What key criteria distinguish NPV from IRR in evaluating capital projects?

Q2: Why is NPV generally considered superior to IRR when deciding between mutually exclusive projects?

Q3: How would you handle multiple IRRs when a project has non‑conventional cash flows?

Q4: What are the limitations of using IRR in capital budgeting?

Q5: Describe a scenario where IRR would be misleading due to scale or timing differences.

Q6: How do you incorporate working capital changes into NPV calculations?

Q7: What impact does the discount rate have on the ranking of two competing projects with different cash flow timings?

Q8: How do you compute adjusted present value (APV) and when is it preferred over WACC‑based NPV?

Q9: How would you reflect inflation (real vs nominal) in your NPV calculation?

Q10: How do you adjust project cash flows for differential taxes or subsidies in NPV analysis?

Q11: What is the crossover rate when comparing two projects with different rate sensitivities?

Q12: How do you treat mid‑year cash flows or half‑year conventions in NPV or IRR?

Q13: How should sunk costs, incremental costs, and opportunity costs be treated in NPV/IRR analysis?

Q14: Describe how real options (e.g., expansion, abandonment) impact capital budgeting via option‑adjusted NPV.

Q15: How would you evaluate a project with a salvage value convertible to a perpetuity?

B. Cost of Capital & WACC

Q16: How do you compute the cost of equity using CAPM, and what are the core assumptions?

Q17: What are alternate models to CAPM, such as the dividend discount model (DDM) or multifactor models?

Q18: How do you estimate the cost of debt, including current yield or yield to maturity?

Q19: How is the weighted average cost of capital (WACC) calculated and what market values should be used?

Q20: How do you adjust WACC for project‑specific risk or different business risk profiles?

Q21: When is unlevered cost of equity used, and how is it computed?

Q22: How does financial distress risk affect WACC and hence project valuation?

Q23: How would you estimate the cost of preferred equity or hybrid instruments?

Q24: Describe how taxes affect WACC and project valuation.

Q25: How do you compute project‑specific WACC if the project has a different risk profile than the parent?

C. Capital Structure

Q26: What are the theoretical foundations of optimal capital structure—MM propositions, trade‑off theory, pecking order, agency theory?

Q27: How do tax shields from debt influence firm value and capital structure decisions?

Q28: What factors would lead a firm to deviate from its target debt ratio temporarily?

Q29: How do financial covenants or credit rating targets impact capital structure strategy?

Q30: How would you evaluate the use of operating versus financial leases in the context of leverage?

Q31: What is the effect of leverage on earnings per share (EPS) volatility and return on equity (ROE)?

Q32: How does CAPM risk adjust for equity and debt proportions when re‑levering beta?

Q33: How would a firm determine its optimal mix of debt, equity, and hybrid instruments?

Q34: What is the impact of inflation or changing interest rates on optimal leverage decisions?

Q35: How can one use adjusted present value (APV) when capital structure varies over a project’s life?

D. Dividend Policy

Q36: What are the main theories of dividend policy—residual theory, bird‑in‑hand, signaling, clientele effects?

Q37: How does a firm balance dividend payouts against internal investment needs in capital budgeting?

Q38: What are the tax implications of different dividend policies for shareholders?

Q39: How does share repurchase compare to dividends as a method of returning cash to shareholders?

Q40: Under what scenarios would a stable dividend policy be preferred over a residual or targeted payout ratio?

E. Integrated Application & Strategy

Q41: A company launches a new project with high variability in cash flows—how would real options analysis shape investment decisions beyond NPV/IRR?

Q42: How do you assess a leveraged buyout’s feasibility using NPV and APV frameworks?

Q43: Given a multinational with access to different markets, how would you estimate a project‑specific discount rate for WACC?

Q44: A firm pursues a merger funded partly by equity—how does this affect its WACC and NPV of combined operations?

Q45: How would you recommend modifying dividend policy after securing high‑return projects with limited internal funds?

Q46: A firm faces credit rating pressure—what capital structure and cost of capital adjustments would you advise?

Q47: How can sensitivity or scenario analysis enhance the robustness of NPV/IRR decisions under cost of capital uncertainty?

Q48: What are the treasury implications of a zero‑debt versus high‑leverage capital structure on cash management?

Q49: How would you reconcile differences between project IRR hurdle rates and overall WACC in decentralized divisions?

Q50: A company is considering a new project denominated in foreign currency—how would you factor financing cost, FX risk, and capital structure in its valuation?