Financial Modeling - Core Concepts Flashcards
Why is money worth more today than it is next year?
Because you could invest that money today and more money with it by next year.
If there were no inflation, would money today still be worth more than money next year?
Yes, because even with no inflation, you could still invest money today and earn more by next year.
You’re considering renting an apartment by paying a very high deposit, but no monthly rent, or paying a much lower deposit and paying monthly rent. How can you decide which option is better?
You have to look at your opportunity cost: How much could you earn with the extra money you save by paying a lower deposit? If you have ideas for high-yielding investments, and you believe you can earn more from them than you’d pay in rent, then it makes sense to choose a lower deposit and monthly rent. On the other hand, if your best idea is putting the money in a checking account at the bank, you’re better off paying the high deposit and skipping monthly rent. But to tell for sure, you’d have to run the numbers and compare your estimated investment income to the rental expense.
Your friend has a new real estate investment idea. He pitches it to you and claims it will generate 10% interest per year. Should you invest in it?
It depends on what your other options are and how the risk of this investment compares to the risk of those other options.
For example, if you could earn 12% elsewhere with the same amount of risk, this opportunity makes no sense.
On the other hand, if you could earn only 7% elsewhere with the same amount of risk, this opportunity makes a lot more sense.
People tend to make the wrong investment decisions because they focus on the potential returns without also considering the risk.
What does the “Discount Rate” mean?
The Discount Rate is like a translator for future money. It helps you figure out how much that money is worth in today’s terms.
There is two ways to think about a discount rate:
1) “Targeted Yield” = Refers to the specific return an investor seeks from an investment. For instance, if an investor requires a 12% return, the discount rate helps determine the amount that investor is willing to invest to secure those future cash flows.
2) Opportunity Cost = If you don’t invest here, how much could you make with your money in other places that are similar?”
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.
Over the long term, you might earn an average of 10-11% per year in the stock market. But in a single year, the market might fall by 30% or rise by 40%, so the return each year varies tremendously.
With debt, by contrast, you’ll earn a fixed amount of interest every single year with a very high certainty. But it’s also highly unlikely that you’ll earn anything close to 10-11% each year over the long term.
What is WACC?
WACC stands for “Weighted Average Cost of Capital,” and it’s 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).
For example, if a company is using 60% Equity and 40% Debt, its Cost of Equity is 10%, and its Cost of Debt is 5%, then its WACC is 60% * 10% + 40% * 5% = 8%.
WACC represents the average annual return you’d expect to earn if you invested in the Debt AND Equity of a company proportionally and held both of them for the long term.
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.
In a specific year, your returns will vary because the stock market can swing around wildly. But WACC represents your long-term, average expected return.
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.”
For example, if your targeted yield is 10%, you’d pay $100 / 10%, or $1,000, for this company.
But if your targeted yield is 20%, you’d pay only $100 / 20%, or $500, for this company.
If there’s 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?
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. Remember that a higher Discount Rate makes a company less valuable, and a higher cash flow growth rate makes a company more valuable.
What might cause a company’s Present Value (PV) to increase or decrease?
A company’s Present Value might increase if:
- 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 lose access to certain investments.
A company’s Present Value might decrease if:
- 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?
It makes sense to invest when:
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 Internal Rate of Return (IRR) is the “effective compounded interest rate on an investment.”
For instance, imagine investing $1,000 today and achieving a $2,000 return after 5 years. The IRR signifies the annual interest rate, compounded each year, needed to turn that $1,000 into $2,000 over 5 years. In this case, it calculates to 14.87%. You can verify this through simple math:
$1,000 * (1 + 14.87%) = $1,148.7
$1,148.7 * (1 + 14.87%) = $1,319.5
$1,319.5 * (1 + 14.87%) = $1,515.7
$1,515.7 * (1 + 14.87%) = $1,741.1
Finally, $1,741.1 * (1 + 14.87%) = $2,000.
The IRR also represent the Discount Rate at which the Net Present Value of an investment equals 0 representing that the PV of the cash flows are equal to the investment amount
What is Net Present Value?
Net Present Value calculate the profitability of an investment by calculating the Present Value of an investment, i.e., the sum of its discounted cash flows, minus the “Asking Price” – what you pay upfront for the investment.
For example, if the Present Value of an investment is $1,000 and the Asking Price is $800, then its Net Present Value is $200.
So, how do you use IRR?
Normally, you calculate IRR and then compare it to the Discount Rate, or WACC, of a project, investment, or company.
If IRR exceeds WACC, it makes sense to invest; if it does not, you should not invest.
For example, you estimate that a project’s IRR is 12%. You could invest in other, similar projects and earn 10%.
Therefore, it makes sense to invest in this project because the IRR exceeds your opportunity cost – what you could earn elsewhere.
