Core Concepts Flashcards
Why is money today worth more than it is next year?
Because you could invest it today and earn more by next year.
Explanation: The first answer is correct: Money is worth more today than it is tomorrow or next year because you could invest it today and earn more by that future date. Inflation does not always exist – sometimes there is deflation – and it’s not the MAIN reason for the time value of
money. Interest rates are not necessarily “very low” all the time, and low interest rates mean that money is not worth quite as much more today (since you will earn less by investing it).
Your friend has a brilliant new investment idea: He wants to acquire local laundromats. He claims that laundromats are low-risk, low-capital businesses, and that you can easily earn 15% per year on your investment. How do you know if you should invest?
Compare this 15% estimated annual return to what you could earn elsewhere – with similar risk levels.
Explanation: The second answer choice is correct: To evaluate an
investment, you have to compare the projected returns to what you
could earn on other, similar investments with similar risk levels. For
example, if you could earn 20% elsewhere with the same amount of risk,
then this opportunity doesn’t make sense. But if you could earn only 7%
elsewhere with the same risk level, this opportunity makes more sense. It
is possible to earn more than the long-term average stock-market
return, so the third answer choice is false.
Why is the Discount Rate higher for stock-market investments than it is for Debt
investments, such as money lent to others?
a. Because the potential returns of stock-market investments are higher.
b. Because stock-market investments also carry greater risk.
c. Because annual returns in the stock market vary tremendously, and you could easily earn more or lose more than you would with Debt.
Explanation: Everything above is true for the reasons stated. The stock
market offers higher potential returns, but also greater risk, and annual
returns tend to fluctuate far more than returns on Debt; interest rates on
Debt are usually fixed or vary only within a specific range.
How much would you pay for a company that generates $100 of cash flow every single
year into eternity?
It depends on your Discount Rate, or “targeted yield.”
Explanation: The third answer choice is correct. For example, if your
targeted yield is 10%, you would pay $100 / 10%, or $1,000, for this
company. But if your targeted yield is 20%, you would pay only $100 /
20%, or $500, for this company. The second answer is wrong because the
question stated that there is no growth. While the statement in the
fourth answer is correct, it’s not the best answer because the MAIN
POINT of the question is that a company’s value to you depends
heavily on your other investment options
A company will generate $300 of cash flow next year, and its cash flow is expected to
grow at 5% per year for the long term. You could earn 12% per year by investing in
other, similar companies. How much would you pay for this company?
4,286
Explanation: Company Value = Cash Flow / (Discount Rate – Cash Flow
Growth Rate), so this one becomes: $300 / (12% – 5%) = $4,286.
Remember that a higher Discount Rate makes a company less valuable,
and a higher cash flow growth rate makes a company more valuable. The
third answer is incorrect because 12% here is your targeted yield since
you could earn that percentage by investing in other, similar companies.
When does it make sense to invest in a company or asset?
a. When its asking price is below its intrinsic value.
b. When the potential returns exceed your opportunity cost
Explanation: The first and second answer choices are correct: You invest
when the company’s current “asking price” or market value is below its
“intrinsic value,” as determined by the Present Value of its future cash
flows (e.g., a stock trades at $10, but its intrinsic value is $15). The second
answer choice refers to an investment where the IRR exceeds the
Discount Rate, which implies the same state: The asking price is below
the intrinsic value.
The third answer is wrong because such a condition would cause the
“Company Value” formula to break; the growth rate cannot exceed the
Discount Rate over the long term. The fourth answer is also wrong
because a monopoly or near-monopoly does not necessarily mean that
the company’s asking price or potential returns are favorable.
What does the internal rate of return (IRR) mean?
a. The IRR is the Discount Rate at which the Net Present Value (NPV) of an
investment is 0.
b. The IRR is the “the effective compounded interest rate on an investment.”
c. If you invest $1,000 today and end up with $2,000 after five years, the IRR represents the interest rate you’d have to earn on that $1,000 each year (compounded) to end up with $2,000 in 5 years.
Explanation: Everything above is true for the reasons stated. Please see
the technical sections of the guide for a full explanation of IRR.
Which of the following factors AFFECT the IRR of an investment?
a. The expected future cash flow and cash flow growth rate.
c. The upfront “asking price.”
d. The expected selling price.
Explanation: The first, third, and fourth answer choices are correct. Since
the IRR is based on the amount you pay upfront, the cash flows the
investment generates afterward, and the selling price at the end, these
three factors all affect it. Your Discount Rate, or opportunity cost, does
NOT impact the IRR because you are solving for the Discount Rate
when you calculate IRR.
Which of the following factors would make the IRR of an investment INCREASE?
a. Its future cash flows are expected to grow at a faster rate.
b. The investment’s expected future selling price increases.
Explanation: The first and last answer choices are correct. Since IRR is
based on the price you pay today, the cash flows you earn afterward, and
the selling price of the investment, higher cash flow growth and a higher
selling price would both increase the IRR. The Discount Rate does not
affect it because you are SOLVING for the Discount Rate with the IRR
calculation, so the second answer is wrong. The third answer is wrong
because a higher asking price would REDUCE the IRR.
A mining company based in North America wants to expand into Turkmenistan by acquiring a promising mineral deposit there. The company’s overall WACC is 12%, but its WACC in Central Asia is 30%. It believes the IRR from this new project will be 25%.Should it expand into Turkmenistan?
No. The IRR is below the region-specific WACC
Explanation: The second answer is correct: You must compare IRR to
WACC on a project or region-specific basis. The WACC for the company as
a whole doesn’t matter because the risk is greater in a country like
Turkmenistan than it is in the U.S., Canada, or even Mexico. In real life,
you would not make this decision based solely on the numbers; this
question is just a simplified example to illustrate the concept.
