BASIC FINANCE CASE STUDY
WALL STREET OASIS TECHNICAL INTERVIEW GUIDE
WEIGHTED AVERAGE COST OF CAPITAL (DISCOUNT RATE) –
OPPORTUNITY COST OF AN INVESTMENT
Cost of Capital Introduction:

An individual's “discount rate” represents what he or she could earn by investing in
another asset (the opportunity cost)
•



In general, if an investment is expected to generate a return in excess of an
individual’s cost of capital, that individual should invest in the project
In general, equities tend to have a higher discount rate because the expected
potential returns are higher, and carry more risk than fixed income (higher risk and
higher reward)
Bonds/debt typically have a lower discount rate because the investor's
compensation is primarily limited to the interest earned on the debt instrument,
rather than appreciation in price of the asset. The risk on the investment is also
generally lower
The decision process is similar for companies when evaluating investments and
projects, but the decision is more dependent on the company's sources of funding
(investor composition)
•
At the firm level, the WACC represents the average discount rate that a
company pays its existing investors (both debt and equity), proportionally
weighted by the company's capital structure (i.e. how much total funding is
comprised of debt vs. equity?)

Interest paid on debt reduces taxable income

Company WACC will depend on the company's size, stability, the interest rate it
pays on its debt, its tax rate, and how volatile its stock is relative to the rest of the
market
Sample Costs of Capital:
Investment Type:
Opportunity Cost (Discount Rate):
Checking Account:
0.1%
High-Yield Savings Account:
2.0%
Govt. Bonds, Corporate Debt, etc.:
5.0%
Public Equities:
10.0%
Discount Rate:
Allocation:
Checking Account:
High-Yield Savings Account:
Bonds / Loans to Friends, Corporate Debt, etc.:
Public Equities:
0.1%
1.0%
5.0%
10.0%
35.0%
30.0%
20.0%
15.0%
Your Personal "WACC":
2.8%
Personal WACC Calculation:
Source of Funding:
After-Tax Discount Rate:
Allocation:
Equity:
Debt:
10.0%
5.0%
65.0%
35.0%
Company WACC:
8.3%
PRESENT VALUE OF AN ASSET
Question: Should we pay $200K for an apartment?

Key Uncertainties / Assumptions:
•
Apartment Sale Value - subject to macroeconomic conditions
•
Annual Cash Flow from Rent - could decline if apartment is vacant
for longer than expected
•
•

Projected Cash Flows:
Asking Price - if seller increases asking price, investment is less
compelling
Opportunity Cost - if we become aware of a favorable alternative
investment, this investment is less compelling
Corporate investments/acquisitions carry similar risks:
•
A targeted company's market value may decline in the future, postinvestment
•
Targeted company may generate much fewer cash flows than
originally projected
•
Seller may increase asking price
•
Other companies / investments offer stronger balance of risk and
reward
"Asking Price" (Initial Investment):
Annual Cash Flow from Renting Apartment:
Apartment Sale Value (Assuming Sale in Year 5):
Our Opportunity Cost (Discount Rate):
Cash Flows:
Rental Income:
Property Sale:
Net Cash Flows:
Present Value (PV):
Should We Invest?

Year 0
$
Year 1
12
$
12
$
$200
$12
$200
2.8%
Year 2
12
$
12
$
Year 3
12
$
12
$
Year 4
12
$
12
$
Year 5
12
200
$
212
$
229
Yes
Conclusion: We should make this investment of $200K today since
this asset has a present value of $229K based on our assumptions
INTERNAL RATE OF RETURN (IRR)
Internal Rate of Return – High Level:

The IRR of a particular investment or asset is another type of Discount Rate,
similar to WACC

Represents the effective compounded interest rate on an investment. The IRR
of a potential investment is not known in advance; it is an output of a particular
investment analysis

Conclusion: We should make this investment of $200K today since this asset
has a projected IRR of 6%, relative to our “internal” cost of capital of 2.8%

If we invested $200K and earned 6% on it each year, compounded annually,
we'd get the equivalent of the cash flows shown in the analysis

Solving for an IRR provides another way to evaluate investments or projects:
does this investment opportunity present the best risk/reward?

The IRR is the Discount Rate at which the NPV equals $0. NPV is like Present
Value, but it is “net” of the cost of the initial investment

Excel’s NPV function does not do this, you must manually do it in a separate
row!
Analysis:
"Asking Price" (Initial Investment):
Annual Cash Flow from Renting Apartment:
Apartment Sale Value (Assuming Sale in Year 5):
Our Opportunity Cost (Discount Rate):
Cash Flows:
Rental Income:
Property (Purchase) / Sale:
Net Cash Flows:
Year 0
$
$200
$12
$200
2.8%
Year 1
12
(200)
(200) $
12
Internal Rate of Return (IRR):
6.0%
Should We Invest?
Yes
$
Year 2
12
$
12
$
Year 3
12
$
12
$
Year 4
12
$
12
$
Year 5
12
200
$
212
$