Finance Interviews: Three Technical Questions You Should Nail

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You’ve aced all your finance classes and are feeling good about landing a solid finance job. You’ve put on a nice suit, practiced your handshake and then get hit with the following question:

How would you calculate a company’s WACC?

You remember that WACC stands for weighted-average cost of capital, but that’s about it. Your classmates who crammed for investment banking interviews seemed to throw the term around left and right, but you didn’t think you would need it.

In fact, understanding a company’s weighted-average cost of capital is important for most finance positions because it’s a rate that many financial decisions are weighed against. It’s also a likely question for a finance interview. So how will you answer it?

The weighted average cost of capital is the weighted average price a company must pay for debt or equity capital. The formula for WACC is straightforward:

WACC = Cost of Debt * Debt / (Debt + Equity) * (1 – tax rate) + Cost of Equity * Equity / (Debt + Equity)

You can calculate the weightings of capital for the equation based on a company’s balance sheet.

For a company with publicly traded debt, you would look up the current yield to maturity for its debt outstanding. For private debt, you would need to look at the rate paid on each piece of private debt on the company’s balance sheet. The weighted average of all these rates would be a company’s cost of debt.

To calculate a company’s cost of equity, you would use the capital asset pricing model (CAPM), which brings us to our next question:

What is the CAPM?

The capital asset pricing model is used to determine a theoretically appropriate required rate of return of an asset. It is often used to determine a company’s cost of equity.

It uses the asset's sensitivity to non-diversifiable or systemic risk — represented as Beta (β) — as well as the expected return of the market, the expected return of a "risk-free" asset and other premiums that are specific to the asset.

The equation for CAPM is:

Ke = Rf + Beta (market risk premium) + (other company-specific premiums)

Where Ke refers to the cost of equity. Rf is the risk free rate, usually assumed to be the yield on 5-10 year treasuries. Other risk premiums might also be added to the cost of the asset such as small company premium or private company premium.

A company’s Beta (β) is a number describing the correlation of its returns with that of the greater financial market. Calculating Beta usually requires doing a regression analysis of a company’s stock performance against a market index such as the S&P 500.

For a private company you’ll have to pull the Betas of some comparable public companies to come up with a proxy Beta. In either case, you’ll have take out the effect of debt leverage to come up with the right Beta, which brings us to our last question:

How do you un-lever a Beta?

The amount of debt or leverage that a company has can affect its Beta. And since we need to isolate a company’s cost of equity, we need to take out the effect of this leverage.

The formula for an un-levered Beta is as follows:

Un-levered Beta = Equity Beta / [ 1 + (1 – tax rate) * Debt / Equity]

The equity Beta would be the Beta you get from Yahoo Finance or by performing a regression analysis of a stock’s performance. Equity in this case is the market value of the company’s equity — its market capitalization.

As you can see from the equation, a company with no debt would not need to un-lever its Beta. The greater the level of debt becomes, though, the smaller the un-levered Beta becomes.

Although these concepts seem like something only an investment bankers would ever want to use, they are in fact central to most of the financial decisions any company makes.

Many company’s will use their WACC as a hurdle rate for making decisions, and as you can see, you also need to understand the capital asset pricing model and Beta in order to calculate WACC.

For all these reasons, you’ll want to be prepared for these questions in any finance interview.

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