Financial Modeling Flashcards
What does the “Discount Rate” mean?
Opportunity cost or “target yield”; represents potential risk and return of investment
Why is the Discount Rate higher for stock-market investments than it is for debt investments, such as government bonds?
Because the risk and return of stock investments are higher
What is WACC?
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
WACC represents the average annual return you’d expect to earn if you invested in the Debt
AND Equity proportionally and for a long time
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 its 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? (with 10% discount rate)
100/10 = 1000
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.
200/(10-4) = 3333
What might cause a company’s Present Value (PV) to increase or decrease?
PV might increase if:
- expected cash flows increase
- expected to grow faster
- discount rate / opportunity cost decreases
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.
What does the internal rate of return (IRR) mean?
The IRR is the “the effective compounded interest rate on an investment.”
The IRR also represents the Discount Rate at which the Net Present Value of an investment
equals 0.
What’s “Net Present Value”?
Net Present Value equals the Present Value of an investment, i.e., the sum of its discounted
cash flows, minus the “Asking Price” - what you pay upfront
How do you use IRR?
If IRR exceeds WACC, it makes sense to invest
What impacts the IRR of a project, investment, or company?
Same factors that impact Present Value, but NOT the discount rate
What would make the IRR increase or decrease?
An investment’s IRR might increase if:
* Its expected future cash flows increase.
* Its future cash flows are expected to grow at a faster rate.
* Its expected selling price in the future increases.
* Its “Asking Price” decreases.
A company is considering expanding by launching a low-cost airline service in Southeast
Asia.
The company’s overall WACC is 11%, but its WACC in this region and industry is 8%. It
believes the IRR from this expansion project will be ~10%.
Should it expand into Southeast Asia?
Yes, because you must compare IRR to WACC on a project or department-specific basis.
Why is valuation more complex than looking at a company’s cash flows, cash flow growth
rate, and an appropriate Discount Rate?
Many different types of “cash flow”; Discount Rate is tricky to estimate based on type of cash flow and time range; “Company value” depends on which investors and parts of the company are included
