Interview Question: "Did WACC go up or down during the crisis?"

freshstrokes's picture
Rank: Monkey | 31

This was a while ago, but I'm not convinced by the interviewer's answer. He asked me "during the crisis, did the overall wacc of most industries go up or down?" I said it went up because of the risk premium went up, causing the cost of equity and cost of debt to go up.

He said I was wrong, because the risk free interest rate went down more than the increase in risk premium. I still don't quite get it..

How is that possible when the credit/TED spreads so damn high at that time? I think I got dinged because of this question.

Can anyone elaborate?

Comments (40)

Jun 25, 2009

for not answering the question like you should have:

"there would be a tradeoff between increased risk premiums and lower risk free rates..." and then giving your answer. either way what you said would have been fine after that.

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Jun 25, 2009

If WACC went down, then why were the only companies raising capital having it shoved down their throat from the government?

Of course it went up. The yield on A-rated credit went from maybe 6.25% to 8%.

Jun 25, 2009

This is a simple analysis but your explanation is right(ish) seeing as liquidity and required returns are negatively correlated. Meaning that seeing as liquidity was going down, expected returns should go up.

However your interviewer was right. The risk free disproportionately affects wacc. It's kinda tricky but I'm sure that it didn't hurt that much if you explained why you thought it went up. let me know if you need an excel sheet to see how it works. I have one handy.

Mar 19, 2012


Jun 25, 2009

Like I said intuitively you'd think it'd go up, but the fact that the risk free rate was so low compared to the historical risk premium it[wacc] went down.

here play with it:

Jun 26, 2009

I don't care how low the risk free rate went down by! The current market risk premium is at historical highs of around 6%. And to figure out the return on equity you need the risk premium multiplied by the levered beta of the company than added to the risk free rate. Yes the risk free rate went down. But not enough to cover up for the increase in risk premium. And during the financial crisis, the levered beta of the company most likely went up as well, making the the require cost of equity even hire.

As for the Cost of Debt that naturally went up for all companies during recent years, as it costs companies more to borrow.

So naturally the WACC went up hire as it is composed of the COE and COD.

So whoever that analyst is that gave you the interview you should find out who the hell his manager is, send an email to that manager and tell him that he has a retarded analyst that should be fired and recruit you instead.

Jun 25, 2009

Just want to make myself clear.
I am sorry Kblue if you don't agree with my analysis, but I'd rather not be insulted like that (even on an internet forum). The OP's questions seemed rather academic to me hence, why I decided to add my opinion. I have given the reason why the OP's answer would be right (I even said that I'd answer it like he would) but also showed how the interviewer came to his conclusion. As can be seen by spreadsheet that I showed, the WACC will indeed go down when the risk free rate goes down against the historical risk premium.

Please take the time and show me how my view if flawed rather than insult me. Go ahead and plug the numbers into that spreadsheet or make a calculation of your own and you will see what I am trying to say.

Jun 25, 2009

In regards to your analysis, few thoughts:
Shouldn't you also include an analysis on the side that looks at the numbers pre-crisis? No real comparison here and I thought the question was how the WACC today compares to the number pre-late 2007.

If your analysis is analyzing the WACC in today's market, it looks a little off:
1. Few companies are able to borrow below 4% in this market. Make sure you're using the current rate.
2. A number of companies have lost a great deal of value in the market. Make sure that your equity value is market instead of book. This should increase the debt weighting in the calculation
3. Your Beta seems low. Is that the latest?

When you consider those items, do you still think the risk free rate is dragging down the entire WACC?

Jun 26, 2009

OK you guys do realize that interviewers FREQUENTLY tell you that you are wrong even if you are right? they do it to see if you get flustered and how you react. the OP got dinged because its painfully obvious that being told hes wrong hurt his ego. he still remembers it months later and complains on an anonymous forum-- imagine how badly he must have been sweating in his suit!

i cant believe there is so much discussion on this. obviously wacc went up!

Jun 26, 2009

Ya know, my initial reaction was "of course cost of capital went DOWN" but then I whipped out my good ol' Excel. Actually, it makes no sense to say the cost of capital went down. Think about this:

1) The risk-free rate tanked, but so did risk premium. Let's be fair and say it's a wash--risk premium increased 300 bps and the risk-free rate fell 300 bps. Ok, so nothing changes.

2) Overall tax rates fall because companies are earning less money. Therefore, the cost of debt goes up proportional with the fall in tax rates.

3) Debt financing becomes much harder to attain; therefore, a company has to shift its capital structure from debt to equity, and equity capital is more expensive (in some cases, much more expensive).

So, by adjusting only the tax rate and the balance of debt and equity in the capital structure to reflect available debt capital in the market, the cost of capital shoots up (unless we are talking FHA residential real estate).

Now, we know that cash has been king as people with liquid cash have been the big movers in project investment. Because the market is so risky, we know that to get these cash holders off the sidelines, a firm will have to offer extremely good returns to get them to move. So, we've shifted from debt into more equity and we've increased the offered equity return to get liquid cash off the sidelines because no one is lending (thus the purpose of TARP).

So in summation, the cost of debt goes up in proportion to falling tax rates (less corporate earnings), the cost of equity increases to entice cash investors, and the capital structure is, out of necessity, shifted more toward more expensive equity capital.

That's the academic description. The problem, of course, is reality. We know that governments "print" money for a reason, and it's why many people are worried about inflation. If the cost of capital were truly going up, we'd see less fear about looming inflation.

Jun 26, 2009

you guys are all nerds.

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Jun 26, 2009

I just wanted to apologize for the insults to aleandro. Nothing personal.

Jun 26, 2009

wouldn't a simple non-technical response be just as good? for instance, if WACC is a reflection of the riskiness of the company's cash flows, in times of great uncertainty investors command a higher return and thus capital is more expensive. I know my answer doesn't take into account capital structure or the risk free rate, but this was just my initial reaction.

Jun 26, 2009

wouldn't a simple non-technical response be just as good? for instance, if WACC is a reflection of the riskiness of the company's cash flows, in times of great uncertainty investors command a higher return and thus capital is more expensive. I know my answer doesn't take into account capital structure or the risk free rate, but this was just my initial reaction.

Jun 26, 2009

I agree with most of VirginiaTech's analysis, but why would tax rates fall? It's simply a percentage of pre-tax income, and the amount of pre-tax income should not have an effect on the tax rate.

Jun 26, 2009

WACC would go up. Period.

Jun 26, 2009

kills, that's a good question. My reasoning is that virtually no corporations pay the full 33% tax rate because of various tax write-offs, structures, loopholes, etc. In other words, companies tend to have disparate tax rates depending on how their accounting works, their earnigns line up, etc. Therefore, it seems somewhat reasonable to conclude that, overall, for the average corporation, their tax rate on earnings will fall--OR they could even become zero, or even less, as they carry over operating losses or incur operating losses.

Jun 26, 2009

effective tax rates vs statutory rate

Jun 26, 2009

Yes, I should have simplified my response to that, dipset. I'm, uhh, a little long-winded sometimes. Gracias.

Jul 9, 2009

The best advice I can give you for technical interview questions that catch you by surprise is to (i) take a deep breath, (ii) step back, and (iii) simplify the problem. Almost any technical question can be at least adequately addressed if you boil it down to its simplest premise.

Let's say a company kept the same projections through the downturn. Very few have, but let's take that as the simplest premise. Would it have become more or less valuable today? Despite the scarcity of a downturn resistant company, it most likely would have traded down, right?Even Wal-Mart, which has benefitted from the developments post Lehman/AIG, has traded down for example.

If you take this as a defensible assumption, then cost of capital has clearly gone up. Projections (i.e future cash flows) remain the same. Yet PV, or more preceisely present value of those same future cash flows, has gone down. Conclusion: discount rates, and by inference WACC levels, have increased.

Jul 9, 2009

Nice to have you back. But your comment (other than paragraph 1) makes no sense as an interview answer. You could just as easily have said to assume WACC hasn't changed but since value is down, projections must be down.

Jul 9, 2009

The question is ridiculous! Even if in a numerical, academic calculation, the risk free rate decreased by enough to outweigh the drastically increased debt spreads across ratings and the highly volatile equity markets, in real life, the marginal cost of capital has definitely gone up. I think your answer would have been better if you had noted that risk free rates have gone down, but I don't think you could defend a lower WACC answer across industries and ratings right now.

VTech - your answer is overly academic. making the assumption that most companies have been able raise equity on a whim over the last year or so is probably only true for strong investment grade companies. I think that you have to look at this question as capital structure status quo, how does the marginal WACC change.

Ghengis - your answer is just wrong. the main reason a company's equity changes value is the EXPECTED future earnings by the market. Walmart could project 20% topline growth and their stock would still have gone down, because no one would believe it. I think backing WACC out of watching an equity trade is impossible.

Jul 12, 2009

VTech - your answer is overly academic. making the assumption that most companies have been able raise equity on a whim over the last year or so is probably only true for strong investment grade companies. I think that you have to look at this question as capital structure status quo, how does the marginal WACC change.

Criticism noted. You're probably right that in this context, they are assuming a static capital structure.

Jul 10, 2009

Anybody who thinks that the cost of raising money to finance business on the average went down during the economic crisis has some sort of severe chromosome mutation, is excruciatingly stupid, and/or has their head so far up their academic over-thinking asses that they can't tell which way is up.

Jul 12, 2009

You could argue that WACC "might" have gone down because the risk-free rate has plummeted, but that's why bankers are paid to think and not just process. Such a statement, while technically defensible, doesn't pass the "smell test."

Jul 15, 2009

I don't understand what the big deal with this question is though I'm unclear on a couple things. Perhaps someone can elaborate on where my logic is wrong?

First off, I'm going to assume this is a general market question, not an industry specific question.


Ke = Risk Free + Beta*(Expected Market Return - Risk Free)

Given that we're looking at the market in general, we'd automatically use a beta of 1, since by definition a beta of 1 infers volatility equal to that of the market. This indicates that any change in the risk free rate would simply offset itself by increasing the market risk premium by an equal amount (what's with all the talk about disproportionate increases?).

The next focus should now be to look at how the market return is affected. I would assume that increased volatility in the markets indicates that the market return number would be marginally higher as increased volatility = increased return by definition. Can someone please comment on this? If this is the case, Ke will increase. Kd has clearly increased as credit has tightened. Therefore, WACC has unequivocally increased.

Perhaps a sanity check to be performed on this is the fact that the markets had dropped by almost 50% at one point... it seems highly unlikely that all of this is due to change in expectation, rather some of it is likely caused by an increased discount rate.

I definitely appreciate the clarification on this - I've read the other posts but a lot of them don't seem to fully cover what I would think to be the main issues given my limited/academic understanding of WACC (I'm a rising junior so I respect the fact that most of the posters here are much more knowledgeable than I am).

Jul 15, 2009


With regard to this comment:

"This indicates that any change in the risk free rate would simply offset itself by increasing the market risk premium by an equal amount (what's with all the talk about disproportionate increases?)."

This is a fair assumption in the classroom, but how it works out it here in the market is called the "risk spread", or in real estate, "pricing". During recessions (or depressions) or times of high volatility or a lot of uncertainty in the market, risk premiums rise disproportionately to interest rates as investors will demand higher returns on their investments. The risk spread in real estate ("pricing") is set in a somewhat subjective, arbitrary manner by individual lenders--this setting of pricing ultimately creates the market, so there is a legit market.

With debt, people simply sell off their debt for safer or other investmetns, causing yields to rise even as interest rates fall. So, if corproate debt were replaced with U.S. Treasuries, you can see how corporate debt yields would rise while the risk-free rate would fall, causing an asymmetric change in risk spread. This is why people might argue that even while the risk-free rate is falling, the Kd is still increasing.

Jul 15, 2009

i agree that he prob. said that you were wrong to fluster you and to see how you would react.

it is pretty clear that WACC has gone up in times of uncertainty without having to look at the equation.

but in terms of an interview answer, i think being calm and collected is more what they're looking for than a technical answer.

Jul 23, 2009

why does the risk free rate go down? sorry guys i'm new to all this

Jul 23, 2009

When there is fear/doubt in the market, investor's enage in a "flight to quality" which is when investors will flee from riskier investments towards very safe investments.

Now, the risk free rate is calculated by looking at the T-Bill yield (be it the 3 month T-Bill, 10 year T-Bill, whatever doesn't matter). As investor's all leave riskier investments and invest in T-Bill's, the price of the T-Bill's will obviously rise. This drives down the yield offered on T-Bills, and therefore drives down the risk free rate.

Mar 19, 2012

This thread is almost 3 years old. These are probably some of the last semi intelligent comments I've made on WSO. I honestly can barely process what I wrote here.

The further we get away from college and the longer we've been in the real world the more detached we get from academic "knowledge". Much of what I said was bull crap, although technically correct.

Mar 19, 2012

I can't believe everyone is arguing whether it went up or down..........

The interviewer is simply testing your understanding of how to calculate WACC. In your answer, you only mentioned cost of equity, specifically just risk premium.

You need to address how cost of equity is calculated, what happened to each variable. Then move on to cost of debt, tax, and overall D/E ratio, making assumptions about whether each went up or down. Finally, coming up with a logical conclusion that is supported by all of your assumptions...

Jan 23, 2013

Sure you can walk through and reason it out element by element, but here's all you need to know:

Companies became less valuable as a result of the financial crisis because the market discounted their future class flows at higher rates. So, WACC must have increased.

That's exactly how I would say it in an interview.

Haters gonna hate

Jun 26, 2013

Would love to revive this thread, and see if anyone can clearly explain the answer to this question..

Jun 27, 2013

Simple answer, way up b/c of the Liquidity Risk Premium built into yields. Credit markets were frozen.

'Before you enter... be willing to pay the price'

Jun 27, 2013

Thanks but Could you explain though how exactly it fits within cost of equity: Ke = Risk Free + Beta*(Expected Market Return - Risk Free)

Jun 27, 2013

Not sure if anyone brought it up yet, but beta measures volatility relative to the market, not the absolute volatility. So if everything is going down pretty uniformly in a market panic selloff, betas may not necessarily go up. If anything, the market risk premium may be affected, but usually people look at long-term MRPs. Overall, you could have a situation where betas & ERPs don't move and the RFR goes down, meaning the equity component of WACC drops along with the debt component due to RFR dropping substantially.

While this may not be how the market values securities in practice, if you simply did a mechanical calculation, you could very easily get lower WACCs during times of market stress.

May 31, 2016

JP Morgan printed out a chart showing WACC did increase from 2007-2009
(for anyone interested, even though this thread is super old haha)

I'm new so can't post a link, but google:
JP Morgan "Bridging the gap between interest rates and investments"

(chart is on page 5)

May 31, 2016