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Common Interview Questions

This is a list of indicative questions commonly asked in interviews. This is neither an exhaustive list nor
intends to serve that purpose. This should strictly be used as a starting point for revising a few topics.

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1. What kind of firms are expected to take the IRR as a tool to evaluate projects? Which firms would
look at NPV?
If there is limited capital, and there are many projects at hand, the firm is likely to use IRR rule.
Smaller, high growth companies would fit this bill.
If there are large amounts of capital, no real issue with raising more when needed, and less
projects available, then the firm would likely use NPV as a method of evaluation. Large publicly
listed companies are likely to use this.

2. Explain the difference in reinvestment assumptions while calculating NPV and IRR. What
implication does it have on the project profile?

NPV assumes that the cash flows are reinvested at the cost of capital (discount rate), while IRR
assumes that they are reinvested at the IRR. (The IRR assumption is a bit difficult to sustain in real
life, and thus many times IRR overstates the return on the project)

3. Explain broad differences in NPV and IRR

The IRR and the NPV will yield similar results most of the time, though there are differences
between the two approaches that may cause project rankings to vary depending upon the
approach used. They can yield different results, especially why comparing across projects because
 A project can have only one NPV, whereas it can have more than one IRR.
 The NPV is a dollar surplus value, whereas the IRR is a percentage measure of return. The
NPV is therefore likely to be larger for “large scale” projects, while the IRR is higher for
“small-scale” projects.
 The NPV assumes that intermediate cash flows get reinvested at the “hurdle rate”, which
is based upon what you can make on investments of comparable risk, while the IRR
assumes that intermediate cash flows get reinvested at the “IRR”.

4. Given the WACC equation, a company should have 100% debt, because that is the point where
the cost of capital will be minimized. Is this correct?
No, the statement is incorrect. A firm cannot have 100% debt, since the equation is dynamic.
Both Cost of Equity and Cost of Debt will change as we get more debt in the firm. Cost of Equity
will increase since the levered beta of the firm will increase, and with more debt, the credit
rating of the firm would fall, and hence cost of debt will increase too.

5. Explain the difference between Dividend Payout, Dividend Rate and Dividend Yield
Dividend Rate – Companies usually use this method to announce the dividend they are paying.
This dividend is as a percentage of the face value of the company’s stock.
Dividend Payout – We can calculate what is the payout ratio by dividing the dividend amount with
the profits. This is the percentage of profits being paid out. Subtracting this from 1 will give us the
retention ratio.
Dividend Yield – We can calculate this by dividing the company’s dividend with the market price.
In a way, this is the actual return the investor makes in the form of dividends, and as a shareholder,
you should be most concerned about this in the measures of dividend.

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6. As a manager, what would your endeavour be while looking at a firm’s working capital?

As a manager, ideally we should try and look at the following scenarios

A sustainable negative working capital is good - Ideally, a negative working capital would mean
that the firm is paying its suppliers after it has been able to dissolve its inventory and receive its
payments. This would be a good situation to be in. Many firms in India enjoy this position. Some
of the notable examples are HUL and Hero Honda.

A steady positive working capital is manageable - Most firms though are not able to maintain
negative working capitals. Smaller firms will have to extend credit to buyers, in order to boost
sales. Inventory control is also not the best in most firms. However, as long as the working capital
requirement is steady, the firm can arrange for it without too much problem

Volatile Working Capital is a problem - If the working capital requirements cannot be projected
steadily, then the firm will have a problem in terms of volatility in cash requirements.

Positive Working Capital turning Negative could be a cause for concern - If the working capital
turns from positive to negative, it could mean that the company is facing trouble paying its
suppliers, and could signal near term distress scenario. This situation needs to be carefully
analyzed.

7. When can we call an asset Risk Free? Why is the government bond considered risk free, even
though we hear the news of governments defaulting?
On a riskfree asset, the actual return should always be equal to the expected return. The variance
of returns should thus be zero.

Now while we consider that the government debt is risk free, in theory, the government can
default. Also, there is one more condition. The traditional yield to maturity calculations (the return
expected on a bond) assume that the intermediate payments get reinvested at the same rate.
However, in real life, when you get payments (such as coupon payments on a bond), they may not
get reinvested at the same rate because interest rates in the markets may have changed.
What that means is that to be completely risk free, by definition the asset should not have any
default risk or reinvestment risk.

A zero coupon government bond in local currency is considered as the risk free security, because
of the following reasons.

Default Risk Free Security - Generally, even the best and largest private companies are liable to
default, and hence are not considered Risk Free in the complete sense. Only Governments are
considered to be risk free in the context of default risk, but this is also only in context of the local
currency (simply because the government can resort to printing money to pay of local currency
debt. This however may not work in case of a foreign currency debt)

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Reinvestment Risk Free Security - As for reinvestment risk, generally the rate used is for a zero
coupon bond issued by the government, which does not have any risk regarding reinvestment of
the interest payments (since there are no interest payments)

8. What kind of firms will you expect to have higher betas? Which ones will have lower betas?

Businesses with a lot of debt would be considered to be riskier by the financial markets and
investors. In other words, businesses with a lot of financial leverage would be considered to be
risky.

Businesses with huge fixed costs, known to have higher operating leverage, will be considered to
be more risky. The reason is that with higher fixed costs, a small change in revenues brings about
a large change in profitability. For example, if a business has a revenue of Rs 100, and only fixed
costs of Rs 90, then a 10% jump in revenues (revenues going up to 110) would bring about a 100%
jump in profitability (Profits jumping from Rs 10 to Rs 20). Similarly, a 10% dip in revenues could
wipe out the entire profits. Hence, the beta for such businesses would be higher.

For example
Safe businesses like Pharma, FMCG have lower betas.
Example – Sun Pharma – 0.8, Lupin – 0.69, Hindustan Unilever – 0.54, ITC – 0.66
Cyclical and volatile businesses, affected by global price moves, like metals have high betas.
Example – Hindalco – 1.84, Tata Steel – 1.73, ONGC – 1.21
Firms in sectors with high capital intensity, and higher debt, also tend to have higher betas
Example - L&T – 1.33, BHEL – 1.33, Adani Ports – 1.33
Banks tend to have higher betas

9. While calculating the Weighted Average Cost of Capital, what weights should we use? Market
Values or Book Values?

The values used should be market values. The reasons why market value is better are listed below

 Market Value reflects today’s business environment. If the company raises equity today,
it is more likely to be closer to the market value than the book value

 Contrary to popular belief, using book values is not conservative. As book value of equity
is far lower than market value, and book value of debt is closer to market value of debt,
using book values will increase the Debt component in the WACC equation. Since Cost of
Equity is higher than Cost of Debt, this will result in a lower WACC, which will become a
more aggressive estimate of value rather than conservative

 It is assumed that market value is more volatile, hence more prone to error. However, the
market value starts discounting the business scenario, whereas book value is inelastic to
such changes.

10. What drives the Price to Earnings Ratio of a company?

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The P/E ratio depends on a variety of factors – such as size, risk etc.

The safer a business, higher the valuation it commands. Cyclical companies such as commodity
companies generally have lower P/E ratios. Example – steel companies typically have P/E ratios in
the high single digits. On the other hand – FMCG companies like HUL and ITC have P/E multiples
higher than 20. The reason is that the risk is much lower in the latter companies, and the earnings
are far more certain. Higher the perceived risk, lower the P/E the market attributes to the stock

Higher the growth – higher the P/E. High growth companies will command higher P/E. The
reasoning will be clear if we define P/E in a slightly different way. If we assume the earnings to be
constant – then P/E can be defined as the number of years in which an investor will get his
investment back – in the form of earnings. Higher the growth, lesser the number of years, and
hence higher the multiple the stock will command

11. In what sectors do we use EV/EBITDA as a metric?

EBITDA is a measure of operating profits of the company – that is profit generated by operations
(operating assets) of the company. Note that this does not include the other income – which is
income derived from other sources such as cash. Thus the multiple is consistent – eliminating the
cash from the calculation.

EV / EBITDA is a useful indicator – since it includes the debt into analysis. Recall that P/E ratio
would be understated if the debt in the company increases – and that does not make allowances
for the debt to be incorporated in the equation. EV/EBITDA takes care of that problem.

It is widely used for firms in the infrastructure, capital goods and telecom space – which require
huge capital investment and where depreciation eats away a large chunk of earnings – thus
distorting the P/E.

12. What do we mean by Enterprise Value? How do we calculate it?

Enterprise Value (EV) is defined as the total market value of the company’s equity and debt. It can
be viewed as the amount needed to buy a company completely, and pay off its liabilities
completely. For example, if a company has a market capitalization of Rs 1000 crore, and debt
outstanding of Rs 1000 crore, and cash on books of Rs 200 crore, then we need only 1800 crores
to buy this outright. Rs 1000 crore for the market shares, and Rs 1000 crore for debt, but we also
get Rs 200 crore cash from the company. Thus EV is given by

EV = Market Cap + Debt – Cash

13. Explain what do we mean by Goodwill?

Goodwill is a number that often comes of the assets side of the balance sheet for firms. While the
common understanding is that goodwill is due to brand value of a company, Goodwill is a
mathematical figure that comes as a balancing figure, in case a company overpays for another one
in an acquisition. Only and only in this case will we see a goodwill number in the balance sheet.
Let’s take an example

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Company A (Rs Crore)

Cash 1000
Fixed Assets 500

Company B (Rs Crore)

Fixed Assets 500

If company A acquires Company B, it should be paying Rs 500 crore for the assets it gets. Let’s
assume however, that it ends up paying Rs 1000 crore (either due to competition or due to
market price being higher).
In this case, the final balance sheet would appear like

Company A (Rs Crore)

Cash 0
Fixed Assets 1000

Technically, if cash of Rs 1000 crore has gone out, balancing figures of Rs 1000 crore should
come in. But only Rs 500 crore worth of assets come in. Thus the balance sheet will not balance
(note we have not changed the liabilities side at all).
The ensure this balancing, we will need to put in a balancing number, assuming that the
company must have overpaid for the goodwill. The resultant balance sheet would thus look like

Company A (Rs Crore)

Cash 0
Fixed Assets 1000
Goodwill 500

14. Give an example of Short Term Provisions on the Balance Sheet

Short Term Provisions are made for Accrued liabilities (also known as accrued expenses), which
are expenses that have been reported on a company’s income statement but which have not yet
been paid because there is no legal obligation to pay them as of the balance sheet date. Common
examples of accrued liabilities are accrued interest payable and accrued wages payable, dividend
payable. In India, taxes payable also come under this.

15. Give an example of Long Term Provisions on the Balance Sheet

Any provisions made for payments which have been accounted for in the income statement, but
will only be paid in the long term. An example would be gratuity

16. Explain what do you mean by minority interest?

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If a company holds less than 100% in another entity, even then, under consolidation principles,
100% of the assets are added up on the assets side. The part that the company does not own, is
hence put on the liabilities side as minority interest.

17. A company reports a profit of Rs 2000 crore. Its depreciation is 350 crore. Receivables last year
were Rs 510 crore, this year are 620 crore. Payables were 340 crore last year and 420 crore this
year. The company has planned a capital expenditure of Rs 1220 crore. Interest cost is 100 crore.
Calculate the CFO, CFI and CFF for the company, assuming the company raises 800 crores in debt,
and pays 400 crore as dividend.

18. How do we calculate the beta for an unlisted firm?

Beta logically should be driven by business decisions. Leverage plays an important role here. The
major determinants of beta will be the type of business the company is in, and its degree of
operating and financial leverage. Since we are looking at similar firms, the operating leverage will
be similar for firms. Hence, beta should be getting determined by the financial leverage, or how
much loan a firm has. The beta can be estimated using the betas of the other firms in the same
segment, or average market beta. Here we need to define 2 more terms, levered and unlevered
beta. Levered beta takes into consideration the debt of the firm – the beta reported for a stock is
usually the levered beta. Unlevered beta is the beta assuming that the firm has no debt.

For unlisted firms, we take sector peers, find their betas, and then do the following process.
-Find comparable firms – in size and business
-Estimate betas of these firms against common index
-Find the unlevered beta for the firms – by using the Debt/Equity ratio and Tax Rate for the firms.

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-Find the average unlevered beta of the sector by average those of the firms
-Use the firm’s current Debt/Equity ratio and Tax rate on this unlevered beta of the sector to find
the levered beta of the firm.

19. How can we calculate cost of debt for a firm?

There are various methods of calculating the cost of debt for firms
• Firms may have specified this in the annual report – notes to accounts section.
• If the company’s bonds are trading in the market, the yield to maturity can give us an idea of
the cost of debt
• If the company’s bonds are not trading, we could look at the credit rating and compare the
yield on similar rated bonds in the markets
• If none of the above are available, we could calculate the cost of debt by dividing the interest
cost by the total loans outstanding.

20. How can a firm book revenue early? Give an example from any sector to explain this concept
A firm may sell some of its products to a group company, thereby registering sales. The idea
would be that the group company would then resell the product. They may not have received
money for this. They will only receive the money once the group company makes the actual sale
of the product. This is no different than the company selling the product in the first place. But
the financial statements will show the sales as registered earlier. This could mislead analysts.

21. Explain with example the concept of Capitalization of any expense.

Some expenses are supposed to be for future revenue creation. These are like capital
expenditure. For example, a pharma company investing heavily in R&D, would want to argue
that this R&D is going to create a revenue sometime in the future. Hence rather than treating it
as an expense, we count this as a fixed asset investment, which can be depreciated over a
period. This process is known as capitalization of expenses. Similar argument can also be made
for interest costs taken for a specific project. If there is a capex of 1000 crore funded by loans,
and there is a cost of 10% on these loans, then the interest cost of Rs 100 crore could be treated
as a part of fixed asset, thereby taking to total asset cost to Rs 1100 crore. This can be
depreciated over the useful life of the asset.

22. Explain how seasonality affects the working capital of a firm?

Firms which caters to products with seasonal demand have to maintain higher levels of working
capital.
• When demand is high, working capital needs to be high. For example, if there is a seasonal
pick up in demand around the festive season, the working capital needs are higher, as the
company maintains higher inventories to manage higher demand.
• When raw materials are seasonal, working capital will be high as the company buys and stores
raw materials for the entire year – example Sugar and Textile industry, where sugarcane and
cotton respectively are seasonal commodities, and their availability as well as prices will vary
across the year

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23. Discuss the implications of working capital management, with reference to firms like Flipkart and
Future Retail (or Amazon and Walmart). What do you think is different in the two firms’ working
capital scenario? What are the elements that you think the two firms should manage well?

The companies discussed are in the retail business. While Flipkart and Amazon are in the e-
commerce space, Future Retail and Walmart are largely hypermarket formats. By nature of the
business, the e-commerce ventures do not need to invest heavily in inventory, as well as do not
end up paying huge amount of rentals for the store space. However, their reach is limited to
people who are using online mode to transact.

Ecommerce firms thus can work with negative working capital (due to less inventory and
practically zero receivables). However, hypermart firms will have to store inventory, and hence
may experience positive working capital.

For a firm like Flipkart, the endeavour has to be to manage the product catalogue well, while
keeping delivery times fast (good logistics) and investing in inventory of items they think move
faster.

For a firm like Future retail – inventory management is key. For most parts, a purchase in retail
stores is kind of impulse purchase, if the store does not have inventory of tomato ketchup for
example, the buyer will not wait for the inventory to come. The buyer instead will go ahead and
buy somewhere else. Thus inventory mismanagement in this case is straight away going to result
in lost sales. Inventory management is thus the key for a retail firm such as Future Retail and
Walmart. They could also deal with payables since they may exercise a good bargaining power
over their suppliers.

24. Explain what is interest coverage ratio. Following are the interest coverage ratios for 4 firms. What
would your analysis be on these firms?

DLF: 1.3
JP Associates: 0.8
Hindalco: 2.2
TVS Motors: 5.3

Interest Coverage Ratio below 1 shows default territory. This is because the company will not be
able to repay the loans from the EBIT they make.
Between 1-2, the ratio shows trouble. Since the company can get into default territory just by a
small fall in sales or rise in costs.
Above 3, the ratio seems comfortable for the company

Based on this, classifying the companies

DLF: 1.3 - Trouble
JP Associates: 0.8 - Default Territory
Hindalco: 2.2 - Caution
TVS Motors: 5.3 - Comfortable

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25. Explain the difference between a bonus and a stock split – with examples. Which one of these is
considered as a sign of the company performing well?

Bonus Stock Split

The share price goes down The share price goes down

The number of shares increase The number of shares increase

Dividend Yield increases Dividend Yield unchanged

Share Capital increases Share Capital unchanged

Face Value remains same Face Value goes down

While broad mechanics remain the same in both bonus and stock split, a company issuing bonus
shares has to ensure that they have enough reserves to be able to make an entry from the
Reserves and Surplus towards the Share Capital. Also, in the case of bonus, since the dividend
per share does not fall, the overall dividend payment goes up. Thus it is considered as a positive
statement from the company, that they have enough profits to sustain the higher dividends.

26. Explain the benefits of over-diversification with an example

We have seen the benefits of diversification. Now if we keep adding securities to the portfolio,
the risk of the portfolio will keep coming down. This will first fall at a faster rate, and then the rate
of decline in risk will slow down. What it means is that as we add stocks to the portfolio, the
standard deviation declines. But after a while, adding more stocks to the portfolio does not reduce
the risk as much.
For example, consider the following 4 portfolios
• With only Tata Steel Standard Deviation: around 40%
• The top 30 stocks in BSE – including Tata Steel Standard Deviation: around 17%
• The top 100 stocks in BSE – including Tata Steel Standard Deviation: around 17%
• The top 500 stocks in BSE – including Tata Steel Standard Deviation: around 17%

We note that as we keep adding stocks to the portfolio, it does not reduce the standard deviation
too much. Infact, above 30 stocks, standard deviation remains constant at 17%.

27. Explain how an airline company can hedge the price of oil for their usage, by using derivative
contracts. Assume that the price today is USD 50 per barrel of oil.

The biggest cost in Airline industry is Fuel Cost and managers would love to contain that with
minimum to zero fluctuation so that overall impact on profits can be minimized.

To contain the volatility, they effectively buy a future contract, that says that you can buy Crude
Oil at a price of USD 50 per barrel next year. In other words, they are making a bet that oil prices

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will be higher than that in the markets by then. Only then will they benefit there. However, here,
the purpose is not to benefit from the price moves, but more to de-risk against adverse moves.

Cases Price Today Price in Future Profit/Loss

Case 1 50 60 (increase in price) 10 per barrel notional
profit
Case 2 50 40 (decrease in price) 10 per barrel notional
loss

Note that in case 1, the company buys fuel from the market at USD 60 per barrel, but gains USD
10 per barrel due to the future contract, thereby bringing the cost down to USD 50 per barrel.
Similarly, in the second case, the company is able to buy fuel at USD 40, but loses USD 10 per
barrel on the future contract, again bringing the cost to USD 50 per barrel. Thus the cost of fuel
has been hedged.

This was an example of hedging. Remember that while hedging protects you against adverse
outcomes, it also removes the chance of the company making higher profits if the prices of crude
fall. That is a bet the company has to make, since the idea is to de-risk themselves and not make
money out of moves in crude oil prices.

28. Can a company do well even if its Return on Equity is going down?
Yes. The ROE can go down if the company is repaying its debt. Recall the Dupont Analysis. The ROE
can be given by
ROE = (Profit margin) * (Asset turnover) * (Equity multiplier)
= (Net profit/Sales) * (Sales/Assets) * (Assets/Equity)
= (Net Profit/Equity)

Note that ROE can go down if Assets by Equity goes down, that is even if a firm is repaying debt,
ROE may decline. It may not necessarily be bad.

29. The current ratio of a company goes from 1 to 1.5, but cash balances have not increased. Would
this be positive for the stock market?
All other things being equal, it may not be positive. This may be because of receivables increasing,
or payables declining. The company may not be able to collect the sales on time. This is a scenario
of working capital cycle deteriorating, and hence the stock market may react negatively.

30. What is the boundary condition for a company to grow in terminal stage in a DCF Valuation?
A company can never grow at a rate higher than the long run nominal GDP growth rate of the
country. Otherwise, mathematically, the company will become bigger than the country. We are
making projections till infinity in the terminal value calculations, and hence the growth rate cannot
be more than the long run growth rate of the country. If we are analysing an Indian firm, it will
not grow at more than 7-8% (since in the very long run, the GDP will grow at 4% real + 4% inflation
kind of numbers approximately – giving an 8% nominal growth rate)

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