Core Concepts

Question 1

Present Value

Answer 1

What future cash flows are worth today, AKA “Intrinsic Value” or “Implied Value”

Question 2

How to make investment decisions?

Answer 2

• compare investment’s present value to asking price
• estimate potential returns (IRR) and compare to opportunity cost

^ These two methods are the same: If Asking Price < Present Value, then IRR > WACC, and if Asking Price > Present Value, IRR < WACC

Question 3

WACC

Answer 3

Most common discount rate used to value companies

% equity * cost of equity + % debt * cost of debt + same items for any other capital sources

Represents the average annual return you’d expect to earn if you invested in the Debt AND Equity of a co proportionally and held both of them for the long term

Question 4

IRR

Answer 4

Effective, compounded interest rate on an investment … it is a way to evaluate yields of different investments … it is the discount rate at which NPV = 0 (NPV is Present Value of Cash Flows Discounted @ WACC - Upfront Investment)

Question 5

The most important formula in finance

Answer 5

Company Value = Cash Flow / (Discount Rate - Cash Flow Growth Rate)

• Cash flow growth rate must be less than discount rate
• DR represents targeted yield or opportunity cost
• If DR is higher, co is worth less (you have better options elsewhere); if DR is lower, co is worth more (your other options aren’t so good)
• If CF is growing more quickly, it’s worth more (you’re willing to pay more for higher growth)
• e.g. if Co generates $100 of CF per yr and grows at 4% per yr, and your targeted yield is 10%, you’d pay $100 / (10%-3%) = $1429 for it
• A company is worth the sum of its discounted cash flows from now into eternity; you must discount these cash flows at a rate appropriate ofr the company’s size, industry and risk

Question 6

Intrinsic Value

Answer 6

Sum of company’s discounted cash flows, from now into eternity, discounted at a rate that is appropriate for the company’s size, industry, and mix of debt/equity

Question 7

Discount Rate

Answer 7

Opportunity cost or “targeted yield.” I.e., if you don’t invest in this company or asset, how much could you earn with your money elsewhere, in similar companies or assets?

The discount rate represents both the potential returns and the risk of other, similar opportunities