Interview Library

And I’ll play the role of the candidate.

Before I begin, what tax rate should I assume?

Got it. When we purchase $10 of inventory with cash, there’s no immediate impact on the Income Statement because we haven’t sold anything yet. On the Statement of Cash Flows, under Cash Flow from Operations, we show an outflow of $10, reducing cash by that amount. On the Balance Sheet, our inventory goes up by $10, and our cash goes down by $10, so everything balances. Once we sell that inventory for $20, the Income Statement shows Revenue of $20 and COGS of $10, leaving us with a $10 profit. That $10 flows into Net Income. On the Statement of Cash Flows, we add back the $10 of Net Income, plus the $10 decrease in inventory, giving us a total $20 increase in cash from operations. On the Balance Sheet, cash increases by $20 while inventory decreases by $10 for a net increase of $10 in assets, and on the other side, Retained Earnings under Shareholders Equity goes up by $10 to reflect the profit. The balance sheet balances.

Give me a few moments to collect my thoughts.

In Year 0, there’s no immediate effect on the Income Statement, because we haven’t incurred any revenue or expense yet. On the Statement of Cash Flows, we see a $100 outflow in Cash Flow from Investing to buy the PP&E. We raise $50 in debt and $50 in equity under Cash Flow from Financing, so the net cash impact is zero. On the Balance Sheet, PP&E increases by $100, debt increases by $50, and equity goes up by $50, so everything balances.

In Year 1, the Income Statement shows $20 of EBITDA. We have $10 of depreciation because $100 spread over 10 years is $10 per year. That means EBIT is $10. We then subtract $5 of interest expense (or 10% on the $50 debt), leaving $5 in earnings before taxes. At a 40% tax rate, we pay $2 in taxes, leaving $3 of Net Income. On the Statement of Cash Flows, we add back the $10 of depreciation to the $3 of Net Income, so Cash Flow from Operations is $13. On the Balance Sheet, cash rises by $13 and PP&E is reduced by $10 of accumulated depreciation for a net increase of $3 in assets, and on the other side, retained earnings under shareholders equity increase by $3. The balance sheet balances.

When you initially get the $10 but haven’t performed the service, there’s no change on the Income Statement since revenue isn’t recognized yet. On the Statement of Cash Flows, you record a $10 inflow in Cash Flow from Operations. On the Balance Sheet, cash goes up by $10 and you create a Deferred Revenue liability for $10. Once you provide the service, you recognize the $10 as revenue on the Income Statement. Net Income increases by $10, assuming no related expenses. On the Statement of Cash Flows, that $10 increase in Net Income is offset by the decrease in Deferred Revenue as a non-cash adjustment, so there’s no additional cash impact in that period. On the Balance Sheet, Deferred Revenue goes down by $10, and Retained Earnings go up by $10.

First, the Equity Value is $6 per share times 50 shares, which is $300. The Enterprise Value formula is Equity Value plus Debt minus Cash. We know Enterprise Value is $500, so we have $500 = $300 plus Debt minus $100. Solving for Debt gives us $300.

Sure! Quantitative factors include higher revenue growth, stronger margins, robust free cash flows, lower debt, and better return metrics like Return on Equity or Return on Invested Capital. Qualitative factors might involve strong brand recognition, competitive advantages like proprietary technology or patents, an effective management team, strategic partnerships, and positive market perception or geographic diversification. These elements can lead to higher valuations by showcasing lower risk, stronger performance, and better growth prospects.

A lower tax rate means higher net income, which translates into higher free cash flows. That typically increases the value in a DCF. However, it also reduces the tax shield on debt, so the after-tax cost of debt may go up slightly. Overall, though, the net effect is an increase in enterprise value because the higher free cash flows tend to have a bigger impact than the slight increase in the cost of debt.

Beta measures market correlation, so a business sensitive to market conditions can have a higher beta than one with unpredictable but uncorrelated cash flows. Thus, the refrigerator company (Company A) likely has the higher beta because its performance is more closely tied to the overall economy and market conditions. Even though Company B has more uncertainty in its cash flows, that risk might be less correlated with economic cycles.

My question would be about cost structure: how much of the company’s costs are fixed versus variable?

That means if revenue goes up by $10 million (which is 10% of $100 million), half of that increase, or $5 million, will flow through to EBITDA because half the costs are variable. So EBITDA would move from $20 million to $25 million.

Decreasing margins can come from rising costs, whether for materials or operations, without a matching increase in revenue. Competitive pressures might force the company to lower prices, cutting into gross margins. Operational inefficiencies can drive costs up. A shift in the product mix toward lower-margin offerings could also contribute. Additionally, higher depreciation or amortization can reduce EBITDA margins, and external factors like inflation or supply chain issues might play a role too.

A company might willingly lower its margins to gain market share, achieve economies of scale, invest in new markets, or strategically price products to defend or expand its competitive position. Over time, these moves can lead to greater overall profitability or a stronger market presence.

Thank you for the opportunity. I appreciate the conversation.