Hedge fund interview question
So recently for one of my interview rounds, I have been asked the following:
You operate a coffee shop in London. Business is running well.
2 possible scenarios that can take place next week and you have the choice of choosing one, which one would you choose to operate in
1. Milk and coffee bean prices go up globally by 20%
2. Shop rent moves up 10%
Assume milk and coffee and rent are about the same proportion of your total cost of operation when the shop is running at full capacity
Just wanted to gather some ideas on how you would answer this and if I should skew my answer in any particular way
it seems like they want to hear your thought process. rent is a fixed rate item that isn’t going back down. market prices are variable. you could also ask for more information in the example to allow extra choices such as hedging coffee
I notice that coffee and milk prices go up globally, whereas that's not specified for rent expense. So for option 1, I know my competitors are experiencing the same cost increases that I am. I assume that coffee is a relatively inelastic good, so I feel good about the industry's ability to pass along a good portion of these cost increases to the consumer without a huge hit to demand. So even though my costs would go up twice as much in option 1, that's the way I lean without the benefit of more info.
Yeah, I agree with this. To add:
Why choose milk and coffee? With milk and coffee moving up globally, likely this will impact various participants in a supply chain squeezing individual margins. So stating that the impact of a 20% global increase will directly translate into a 20% increase to your COGS seems unlikely. Next to this: Given you are a coffee shop, likely you are long on forward contracts in both dairy and coffee which presents a trading opportunity (e.g. you have long-term contracts at fixed prices with coffee and dairy suppliers). You can renegotiate the contracts depending on your view of these two markets and the response of your competitors.
Why choose rent? The impact of a rent increase is a direct impact to your bottom line you can't really trade around. However, it is a fixed cost input with an asset that can generate a variable profit margin. You can for example argue that the fact that rent increases by 10% could be a reflection of an improvement of average income of population in the area where your coffee shop is active. This could justify offering coffee at a higher margin (higher rents, more premium segments, more premium coffee).
So either way works, it boils down to how you communicate/sell on the idea, and demonstrate your ability to see a profitable trading opportunity.
I accept the rent increase, then file bankruptcy to reject the lease and reorganize as a licensor of my coffee brand IP globally...?
It's a question about operating leverage and fixed-costs vs. variable costs. Rent is a fixed cost that you have to pay regardless of how many cups of coffee you sell and so an increase in rent will increase your operating leverage and make you more sensitive to changes in volumes (the number of cups you sell every day). An increase in COGS (the milk and coffee) is a variable cost and, depending on the price elasticity of your product, may or may not directly impact volumes.
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