Core Concepts Flashcards
What does the “Discount Rate” mean?
The Discount Rate represents the opportunity cost or your “target yield.”
In other words, if you don’t invest in this company or asset, how much could you earn with your money elsewhere, in similar companies or assets?
It represents both the potential returns and the risk of other, similar opportunities.
If the Discount Rate is higher, both the potential risk and returns are _____?
Higher
If the Discount Rate is lower, both the potential risk and returns are _____?
Lower
Why is the Discount Rate higher for stock-market investments than it is for debt investments such as government bonds?
Because the risk and potential returns of stock-market investments are higher.
What is WACC?
WACC = Weighted Average Cost of Capital, and it is the most common Discount Rate used to value companies.
To calculate it, you multiply the % Equity in a company’s capital structure by the “cost” of that Equity, multiply the % Debt in the company’s capital structure by the “cost” of that Debt, and add them up (and factor in any other sources of capital).
What does WACC represent in simple terms?
WACC (Weighted Average Cost of Capital) represents the average cost a company pays to finance its operations through various sources of capital. In simple terms, it’s the blended cost of using both debt and equity to fund a business.
It sets the minimum return a company must earn on its existing assets to satisfy its creditors, owners, and other providers of capital.
Companies use WACC as a hurdle rate when evaluating new projects or acquisitions. If an investment’s expected return is lower than the WACC, it may not be worth pursuing.
You estimate that a company’s WACC is 8.0%. What does that mean?
It means that if you invested proportionally in both the company’s Equity AND Debt, you’d expect to earn 8.0% per year from the investment, on average, if you hold it for the long term.
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 “target yield.”
For example, if your targeted yield is 10%, you’d pay $100 / 10%, or $1,000 for this company.
But if your target yield is 20%, you’d pay only $100 / 20%, or $500 for this company.
If there is no growth, the formula is Company Value = Cash Flow / Discount Rate.
A company generates $200 of cash flow today, and its cash flow is expected to grow at 4% per year for the long term.
You could earn 10% per year by investing in other, similar companies. How much would you pay for this company?
Compan Value = Cash Flow / (Discount Rate - Cash Flow Growth Rate), where Cash Flow Growth Rate < Discount Rate.
So, this one becomes: $200 / (10% - 4%) = $3,333.
A higher Discount Rate makes a company ______ valuable, and a higher Cash Flow Growth Rate makes a company ______ valuable.
Less / More
What might cause a company’s Present Value (PV) to increase?
Its expected future cash flows increase.
Its future cash flows are expected to grow at a faster rate.
Our “opportunity cost,” or Discount Rate, decreases because we gain access to better investment opportunities.
What might cause a company’s Present Value (PV) to decrease?
Its expected future cash flows decrease.
Its future cash flows are expected to grow at a slower rate.
Our “opportunity cost,” or Discount Rate, increases because we gain access to better investment opportunities.
How do you decide whether or not to invest in a company or asset?
1) Its Asking Price is below its Intrinsic Value
2) The Potential Returns exceed your Opportunity Cost
You would also review the qualitative and market factors and make sure that all of those support your decision well.
What does the Internal Rate of Return (IRR) mean?
The IRR is “the effective compounded interest rate on an investment.”
For example, if you invest $1,000 today and end up with $2,000 after 5 years, the IRR represents the interest rate you’d have to earn on that $1,000, compounded each year, to get $2,000 in 5 years.
The IRR also represents the Discount Rate at which the Net Present Value of an Investment equals 0.
Why is the IRR considered a “compounded” interest rate?
The word “compounded” subtly communicates that IRR assumes all cash flows are reinvested at the same rate, which is an important assumption of the IRR calculation.
