Finance Questions Flashcards
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.”
If your Discount Rate is 10%, meaning you could earn 10% per year in companies with similar risk/potential return profiles, you would pay $100 / 10% = $1,000.
But if your Discount Rate is 20%, you would pay $100 / 20% = $500.
A company generates $200 of cash flow next year, 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?”
Company 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.
“What might cause a company’s Present Value (PV) to increase or decrease?”
- Increase if discounted rate decreases
- Increase if future cash flow increases
- Decrease if discounted rate increases
Internal rate of return (IRR)
the Discount Rate at which the Net Present Value of an investment, i.e., Present Value of Cash Flows – Upfront Price, equals 0.
You can also think of it as the “effective compounded interest rate on an investment” – so, if you invest $1,000 today, end up with $2,000 in 5 years, and contribute and earn nothing in between, the IRR is the interest rate you’d have to earn on that $1,000, compounded each year, to reach $2,000 in 5 years.
A company runs into financial distress and needs cash immediately. It sells a factory that’s listed at $100 on its Balance Sheet for $80. What happens on the 3 statements, assuming a 40% tax rate?
Income Statement: Record a Loss of $20 on the Income Statement, which reduces Pre-Tax Income by $20 and Net Income by $12 at a 40% tax rate.
Cash Flow Statement: Net Income is down by $12, but you add back the $20 Loss since it’s non-cash. You also show the full proceeds, $80, in Cash Flow from Investing, so cash at the bottom is up by $88.
Balance Sheet: Cash is up by $88, but PP&E is down by $100, so the Assets side is down by $12. The L&E side is also down by $12 because Retained Earnings fell by $12 due to the Net Income decrease, so both sides balance.
Debt, Equity, Cost of Debt
Cost of debt will help up until a certain point that additional debt will make the cost of equity more expensive. WACC will be lower initially then rise. Higher then lower in implied value of DCF
What are the advantages and disadvantages of EV / EBITDA vs. EV / EBIT vs. P / E as valuation multiples?
Measure profitability with variations depending on 1) to whom $ is available to 2) OpEx and CapEx 3) interest, taxes, and non-core business activities
EV / EBITDA is better in cases when you want to completely exclude the company’s CapEx, Depreciation, and capital structure.
EV / EBIT is better when you want to exclude capital structure but partially factor in CapEx and Depreciation. It is common in industries where those items are key value drivers for companies (e.g., manufacturing).
The P / E multiple is not terribly useful in most cases because it’s affected by different tax rates, capital structures, non-core-business activities, and more – so, you often use it in the interest of “completeness” or because you want a multiple that reflects a company’s true bottom line.
Also, it’s important in industries such as commercial banking and insurance where you do need to factor in the interest income and expense.
EBIT
Core business profitability = operating income adjusted for non-recurring charges
EBITDA
Core recurring CF from operations EBIT + D&A
Net Income
Profit after taxes, impact of capital structure, and non-core business activities
