Tricky finance interview question
Hey all,
I had a short interview with a Finance department. The interviewer was not happy with my answer. He asked me:
Question: "Say your marketing director comes to you and asks for $100,000 to fund his marketing project in Walmart, would you give it to him"?
Me: Well, initially I would see what kind of rates of return marketing projects in Walmart have given in the past. I would attempt to construct an IRR schedule to see if the rate of return is greater than the cost of capital, if so I would pass him the money.
Interviewer: Well, what will you compare IRR to?
Me: How are we planning to fund the $100,000 in cash?
Interviewer: Using our cash.
Me: I would then compare it to our cost of equity.
Interviewer: Well, I'm taking the $100,000 out of retained earnings.
Me: Hence, the cost of equity sir.
Interviewer: Hmph. Moving on.
What was the proper way to answer this question guys?
I don't know the answer to this, but I'm assuming they would want you to be a little more analytical in how you answered. Instead of comparing prior Walmart project's ROR to the company's Cost of Capital, you probably should have mentioned the questions you would ask this director. Remember, he's a marketing director, not a finance director.
What are our current sales in Walmart? How much do you see those sales increasing if we do this marketing investment? Do you have numbers to back that up? Based off your answer, you are saying that we will get a xx% ROR. Is this a good investment? How is this marketing campaign different than our historical Walmart marketing campaigns? How long will our higher sales be sustained, or will we have to do another marketing campaign? Are there other markets where this investment could be spent with a greater ROR? (target, Meijer, etc)
The thing with corporate finance is that isn't so much about all the equations that you learn in finance class about IRR, DCF, NPV, WACC and whatever. Sure, those are used sometimes, but in corporate it's a little more about the line of thinking than about all the equations.
Retained earnings is essentially residual net income so even though it comes from the equity portion of the B/S, that doesn't matter. You would pretty much NEVER use cost of equity as your hurdle for a relatively small project like that because the money is so intermingled that there's no way to say if it was generated using debt, equity, or both. So you would use your company's cost of capital.
That said, your company probably is not going to be happy with a model that gives you 12% when their cost of capital is 10%. There's typically all kinds of corporate allocations and back-office support charges that don't really get baked into you typical model. For instance, at a very large corporate I've worked for, they only take projects generate 5-7% more than their cost of capital due to the aforementioned issues.
Totally agree with Dan_yo. The question is meant to see how you think strategically, not just if you know the definition of IRR/ROI. In the real world, not everything is cut and dry. You may run a marketing program even if it has a negative return, particularly with a customer as big as Walmart, who may represent a high % of your overall sales. You may also run a marketing program to protect shelf space, block a competitor from running a program, or just because it's the best way to introduce new innovation.
Thank you guys for the insight! I now know how to approach these kind of problems and I was so blinded with equations I made the mistake of forgetting about logic!
You forgot to ask how many rollbacks and smiley faces that $100k translates into
Returns are important, but this answer didn't go deep enough. There are more things than just the cost of financing that go into the lifecycle of a company that are important to consider when looking at new projects. I know my boss would never really care about paper returns, because he's not a finance guy. I mean sure if they're good then great, but when it comes down to it, he'll override me based on what he thinks is important and best for the company. You needed to show more depth in probing this type of situation to take into account all of the factors relevant to the business.
I don't know the company, position interviewing for or context, but you likely missed the boat entirely.
As @dan_yo23" stated there are times for IRR, NPV, WACC, etc but they're rarely used in day-to-day management of a company. In my prior role this is how that conversation would've gone:
Director: I'm spending $100k on marketing targeted to Walmart. Me: Why? D: They're the largest retailer in the US and reach out target demographic, it's a potential gold mine for us. M: Why do you think we'll be successful when we haven't gotten them in the past? D: blah, blah, blah, blah
M: OK, but you only have $700k in expenses budgeted for the year. $200k for Costco, $200k for Target, $100k Tradeshow, $100k travel and $100k for the new Marketing manager. Where should we cut to fund this $100k? D: I can cut travel to $75k, hire the new person mid year and take $25k from Costco. M: Costco's our biggest customer, will this hurt our sales there? D: No, I only ever needed $100k, I just padded my budget.
I would eventually make sure I understand key drivers of why we weren't in Walmart in the past, but will be successful now. Also, the likely margins on the product, etc... However, this sounds more like a management question than a finance-cost of capital type question.
Dead on.
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