Interview question

I interviewed with a hedgefund(Long-Short and other things), and screwed on this question: Value the “money machine” which will print \$1 million every year. What do you think, guys?

Can calculate by using the perpetuity formula: Value=Cash Flow/Discount Rate Your cash flow is 1mln… Pick the appropriate discount rate and dont forget the compounding effect…

Seems like a perfect dividend discount model question (no growth) \$1mln divided by whatever discount rate you assume. If the money machine is a sure thing, then divided by the risk free rate would be your max value (\$20mn give or take). You could then make assumptions about the riskyness of the firm and adjust the valuation downwards since the discount rate will be higher.

The question is the discount rate and the useful life of the machine. If the machine always works forever and there is no doubt about the output, use the risk free rate. If the machine has maintenance costs, subtract these from the cash flows. If either costs or output is uncertain, you’ll need a risk premium on top of the risk free rate. This is more challenging. One way is to look at covariance with the market and use the security market line.

Agree on the maintenance cost and useful life assumption. As for how to assess the discount rate, such as how to determine the MRP, still confusing.

I think a hedge fund assumes that you would know how to discount a stream of cash flows into perpetuity. They’re probably asking this question to see if you could come up with the answer in your head. That being said what do you get?

I believe the discount rate should include a premium to compensate the risk of getting busted.

Usually these type of questions test your ability to get at the relevant facets of a decision. If you are just asked how to do a PV of a million dollars a year guaranteed, that’s one thing. They don’t tell you if the machine needs to be repaired, if the police are going to bust you, if inflation is a major issue, if the machine has a useful life, etc… When I’ve encountered questions like this, they’re usually trying to see how many facets of the situation do you start to include in your analysis. If you think out loud and start to say things like “do we need to repair, is this our main currency, etc.,” that is usually good.

If it’s risk free, you should just say “about 20M” because a long bond and a perpetuity are just not that much different (perpetuities have duration and all). A long bond is paying 4.5%. So just add a little to get to the nearest thing you can do in your head and the answer is 20M in less than 2 seconds.

What a stupid question.

I agree with BCHADwick, I was rushing to give answer w/o saying about the repairs and life… I don’t think they liked my answer… therefore no luck on this job It’s one of the interviews I was very disappointed at. I mean I fail to nail down the job many times, but this one I feel I didn’t presented myself well at all and was looked as too naive on investment … BTW, how do you guys think one could appears more aggressive? That’s my weakness from their feedback. I remembered one thing that their PM called my DCF analysis no use since I can’t get accurate g. Should I defense it while admit there are some guessing needed? hedge fund use multiples which are even blur, of cause they only look at 1-3 quarters. What do ya think? Steve

I think by aggressive, it implies that you should ask more questions. How far can this job take you? How long does it take for you to communicate with clients? What type of responsibilities will you be take on in the next 2 years? In general, just show that you are willing to know more about the role.