Outputs

Question 1

What is the time value of money concept?

Answer 1

The time value of money (TVM) is the concept that a sum of money is worth more in the hand now than the same sum will be at a future date, due to its earning potential in the interim. Money in hand can be invested and increase in value.

Question 2

What is the formula for the time value of money?

Answer 2

The most fundamental TVM formula takes into account the following variables:
• FV = Future value of money
• PV = Present value of money
• i = interest rate
• n = number of compounding periods per year
• t = number of years
Based on these variables, the formula for TVM is:
FV = PV x [ 1 + (i / n) ] (n x t)

Question 3

How does the time value of money relate to opportunity cost?

Answer 3

Opportunity cost is key to the concept of the time value of money. Money can grow only if it is invested over time and earns a positive return.

Money that is not invested loses value over time. Therefore, a sum of money that is expected to be paid in the future, no matter how confidently it is expected, is losing value overtime.

Question 4

What is a discount rate?

Answer 4

The discount rate refers to the interest rate used in the discounted cash flow (DCF) analysis to determine the present value of future cash flows.

In discounted cash flow analysis, the discount rate expresses the time value of money and can make the difference between whether an investment project if financially viable or not.

Question 5

How does the discount rate work in cash flow analysis?

Answer 5

Discounted Cash Flow analysis is used to estimate the value of an investment based on it expected future cash flows. Based on the concept of the time value of money, DCF analysis helps assess the viability of a project or investment by calculating the present value of expected future cash flows using a discount rate.

• Such an analysis begins with an estimate of the investment that a proposed project will require.
• Then, the future returns it is expected to generate are considered.
  Using the discount rate, it is possible to calculate the current value of such future cash flows.
• If the net present value is positive, the project is considered viable. if it is negative, the project isn’t worth the investment.

Question 6

How does the discount rate relate to the interest rate?

Answer 6

The discount rate can be thought of as the interest rate you need to earn on a given amount of money today to end up with a given amount of money in the future.
- It is important to choose a realistic number for the discount rate, but often you can only make an educated guess.

Question 7

What is the right discount rate to use?

Answer 7

If a business is assessing the potential viability of a project, the weighted average cost of capital (WACC) may be used as a discount rate. - This is the average cost the company pays for capital from borrowing or selling equity. - In effect the interest rate a company has to pay to borrow money.

Question 8

What effect does a higher discount rate have on the time value of money?

Answer 8

Future cash flows are reduced by the discount rate, so the higher the discount rate, the lower the present value of the future cash flows. A lower discount rate leads to higher present value.
When the discount rate is higher, money in the future will be worth less than it is today. It will have less purchasing power.

A higher discount rate can be thought of as a higher potential rate of interest that is lost in the time between the present and receipt of the expected future cash flow.

Question 9

What is Present Value (PV)?

Answer 9

Present value is the current value of a future sum of money or stream of cash flows given a specified rate of return.
Future cash flows are discounted at the discount rate, and the higher the discount rate, the lower the present value of the future cash flows.

Present value shows that money received in the future is not worth as much as an equal amount received today.
Unspent money today could lose value in the future by an implied annual rate due to inflation or the rate of return if the money was invested.
Calculating present value involves assuming that a rate of return could be earned on the funds over the period.

There are two reasons why a given sum is worth more received today than the same amount received in the future:

• Money today, can earn interest if invested.
• The same amount of money in the future will have lower buying power due to inflation.

Question 10

How does the discount rate affect present value (PV)?

Answer 10

The discount rate is the investment rate of return that is applied to the present value calculation.

In other words, the discount rate would be the foregone rate of return if an investor chose to accept an amount in the future versus the same amount today.

The discount rate that is chosen for the present value calculation is highly subjective because it’s the expected rate of return you’d receive if you had invested today’s dollars for a period of time.

Question 11

What is the formula for Present Value?

Answer 11

Present Value = FV/(1+r)^n

Where: FV = Future Value
r = Rate of Return
n = Number of periods

Question 12

How is present value calculated and why is it important?

Answer 12

Present value is calculated by taking the future cashflows expected from an investment and discounting them back to the present day.
To do so, the investor needs three key data points: the expected cashflows, the number of years in which the cashflows will be paid, and their discount rate. The discount rate is a very important factor in influencing the present value, with higher discount rates leading to a lower present value, and vice-versa.

Present value is important because it allows investors to judge whether or not the price they pay for an investment is appropriate

Question 13

What is Net Present Value (NPV)?

Answer 13

Net present value (NPV) is the difference between the present value of cash inflows and the present value of cash outflows over a period of time. NPV is used in capital budgeting and investment planning to analyse the profitability of a projected investment or project. NPV is the result of calculations used to find today’s value of a future stream of payments.

Net present value, or NPV, is used to calculate the current total value of a future stream of payments.
If the NPV of a project or investment is positive, it means that the discounted present value of all future cash flows related to that project or investment will be positive, and therefore attractive.
To calculate NPV, you need to estimate future cash flows for each period and determine the correct discount rate.

Question 14

What is the difference between a positive and a negative Net Present Value (NPV)?

Answer 14

A positive NPV indicates that the projected earnings generated by a project or investment - in present dollars - exceeds the anticipated costs, also in present dollars. It is assumed that an investment with a positive NPV will be profitable.
An investment with a negative NPV will result in a net loss. This concept is the basis for the Net Present Value Rule, which dictates that only investments with positive NPV values should be considered.

Question 15

What are the limitations of Net Present Value?

Answer 15

Gauging an investment’s profitability with NPV relies heavily on assumptions and estimates, so there can be substantial room for error.
Estimated factors include investment costs, discount rate, and projected returns.
A project may often require unforeseen expenditures to get off the ground or may require additional expenditures at the project’s end.

Question 16

What is a discounted cash flow?

Answer 16

Discounted cash flow (DCF) is a valuation method used to estimate the value of an investment based on its expected future cash flows. DCF analysis attempts to figure out the value of an investment today, based on projections of how much money it will generate in the future.

• Discounted cash flow (DCF) helps determine the value of an investment based on its future cash flows.
• The present value of expected future cash flows is arrived at by using a discount rate to calculate the DCF.
• If the DCF is above the current cost of the investment, the opportunity could result in positive returns.
• Companies typically use the weighted average cost of capital (WACC) for the discount rate, because it takes into consideration the rate of return expected by shareholders.
• The DCF has limitations, primarily in that it relies on estimations of future cash flows, which could prove inaccurate.

Question 17

How do you calculated DCF?

How does DCF differ from NPV?

Answer 17

Calculating the DCF involves three basic steps—one, forecast the expected cash flows from the investment. Two, you select a discount rate, typically based on the cost of financing the investment or the opportunity cost presented by alternative investments. Three, the final step is to discount the forecasted cash flows back to the present day, using a financial calculator, a spreadsheet, or a manual calculation.

DCF is not the same as NPV, although the two concepts are closely related. Essentially, NPV adds a fourth step to the DCF calculation process. After forecasting the expected cash flows, selecting a discount rate, and discounting those cash flows, NPV then deducts the upfront cost of the investment from the investment’s DCF.

Question 18

What is the internal rate of return?

Answer 18

The internal rate of return (IRR) is a metric used in financial analysis to estimate the profitability of potential investments.
IRR is a discount rate that makes the net present value (NPV) of all cash flows equal to zero in a discounted cash flow analysis.
IRR is the annual return that makes the NPV equal to zero.
Generally speaking, the higher an internal rate of return, the more desirable an investment is to undertake. IRR is uniform for investments of varying types and, as such, can be used to rank multiple prospective investments or projects on a relatively even basis.

Question 19

What does IRR actually mean?

Answer 19

The internal rate of return (IRR) is a financial metric used to assess the attractiveness of a particular investment opportunity. When you calculate the IRR for an investment, you are effectively estimating the rate of return of that investment after accounting for all of its projected cash flows together with the time value of money. When selecting among several alternative investments, the investor would then select the investment with the highest IRR, provided it is above the investor’s minimum threshold. The main drawback of IRR is that it is heavily reliant on projections of future cash flows, which are notoriously difficult to predict.

Question 20

How can IRR be used alongside WACC?

Answer 20

Most IRR analyses will be done in conjunction with a view of a company’s weighted average cost of capital (WACC) and NPV calculations.
IRR is typically a relatively high value, which allows it to arrive at an NPV of zero. Most companies will require an IRR calculation to be above the WACC. WACC is a measure of a firm’s cost of capital in which each category of capital is proportionately weighted. All sources of capital, including common stock, preferred stock, bonds, and any other long-term debt, are included in a WACC calculation.
In theory, any project with an IRR greater than its cost of capital should be profitable. In planning investment projects, firms will often establish a required rate of return (RRR) to determine the minimum acceptable return percentage that the investment in question must earn to be worthwhile. The RRR will be higher than the WACC.
Any project with an IRR that exceeds the RRR will likely be deemed profitable, although companies will not necessarily pursue a project on this basis alone. Rather, they will likely pursue projects with the highest difference between IRR and RRR, as these likely will be the most profitable.

Question 21

What are the limitations of IRR?

Answer 21

However, it is not necessarily intended to be used alone. IRR is typically a relatively high value, which allows it to arrive at an NPV of zero. The IRR itself is only a single estimated figure that provides an annual return value based on estimates. Since estimates in IRR and NPV can differ drastically from actual results, most analysts will choose to combine IRR analysis with scenario analysis. Scenarios can show different possible NPVs based on varying assumptions.

In some cases, issues can also arise when using IRR to compare projects of different lengths. For example, a project of short duration may have a high IRR, making it appear to be an excellent investment. Conversely, a longer project may have a low IRR, earning returns slowly and steadily. The ROI metric can provide some more clarity in these cases, although some managers may not want to wait out the longer time frame.

Question 22

What is Weighted Average Cost of Capital (WACC)?

Answer 22

The weighted average cost of capital (WACC) is a calculation of a firm’s cost of capital in which each category of capital is proportionately weighted. All sources of capital, including common stock, preferred stock, bonds, and any other long-term debt, are included in a WACC calculation.

Can be used as a hurdle rate against which companies and investors can gauge ROIC performance.
WACC is commonly used as the discount rate for future cash flows in DCF analyses.

Weighted average cost of capital measures a company’s cost to borrow money, given the proportional amounts of debt and equity a company has taken on.
The higher the WACC, the less likely it is that the company is creating value, because it has to overcome more expensive borrowing costs to make a profit.

Question 23

What is EBIT?

Answer 23

Earnings before interest and taxes (EBIT) is an indicator of a company’s profitability. EBIT can be calculated as revenue minus expenses excluding tax and interest. EBIT is also referred to as operating earnings, operating profit, and profit before interest and taxes.

• EBIT (earnings before interest and taxes) is a company’s net income before income tax expense and interest expenses are deducted.
• EBIT is used to analyse the performance of a company’s core operations without the costs of the capital structure and tax expenses impacting profit.
• EBIT is also known as operating income since they both exclude interest expenses and taxes from their calculations. However, there are cases when operating income can differ from EBIT.

EBIT = Revenue - Cost of goods sold (COGS) - Operating Expenses

EBIT = Operating Earnings = Operating Profit = Operating Income

Question 24

Why is EBIT important?

Answer 24

EBIT is an important measure of a firm’s operating efficiency. Because it does not take into account indirect expenses such as taxes and interest due on debts, it shows how much the business makes from its core operations.

By ignoring taxes and interest expense, EBIT focuses solely on a company’s ability to generate earnings from operations, ignoring variables such as the tax burden and capital structure. EBIT is an especially useful metric because it helps to identify a company’s ability to generate enough earnings to be profitable, pay down debt, and fund ongoing operations.

Question 25

Why is EBIT important to companies in the Energy industry? (Asset owners)

Answer 25

EBIT is helpful in analysing companies that are in capital-intensive industries, meaning the companies have a significant amount of fixed assets on their balance sheets. Fixed assets are physical property, plant, and equipment and are typically financed by debt. For example, companies in the oil and gas industry are capital-intensive because they have to finance their drilling equipment and oil rigs.
As a result, capital-intensive industries have high-interest expenses due to a large amount of debt on their balance sheets. However, the debt, if managed properly, is necessary for the long-term growth of companies in the industry.
Companies in capital-intensive industries might have more or less debt when compared to each other. As a result, the companies would have more or fewer interest expenses when compared to each other. EBIT helps investors to analyse companies’ operating performance and earnings potential while stripping out debt and the resulting interest expense.

Question 26

What is EBITDA?

Answer 26

EBITDA, or earnings before interest, taxes, depreciation, and amortization, is a measure of a company’s overall financial performance and is used as an alternative to net income in some circumstances. EBITDA, however, can be misleading because it strips out the cost of capital investments like property, plant, and equipment.
This metric also excludes expenses associated with debt by adding back interest expense and taxes to earnings. Nonetheless, it is a more precise measure of corporate performance since it is able to show earnings before the influence of accounting and financial deductions.

• EBITDA is a widely used metric of corporate profitability
• EBITDA can be used to compare companies against each other and industry averages.
• EBITDA is a good measure of core profit trends because it eliminates some extraneous factors and provides a more accurate comparison between companies.
EBITDA can be used as a shortcut to estimate the cash flow available to pay the debt of long-term assets.

Question 27

What is a hurdle rate?

Answer 27

A hurdle rate is the minimum rate of return on a project or investment required by a manager or investor. It allows companies to make important decisions on whether or not to pursue a specific project. The hurdle rate describes the appropriate compensation for the level of risk present—riskier projects generally have higher hurdle rates than those with less risk.

• A hurdle rate is the minimum rate of return required on a project or investment.
• Hurdle rates give companies insight into whether they should pursue a specific project.
• Riskier projects generally have a higher hurdle rate, while those with lower rates come with lower risk.
• Investors use a hurdle rate in a discounted cash flow analysis to arrive at the net present value of an investment to deem its worth.
Companies often use their weighted average cost of capital (WACC) as the hurdle rate.

Question 28

What are the most important considerations for determining an appropriate hurdle rate?

Answer 28

In order to determine the rate, the following are some of the areas that must be taken into consideration:

• Associated risks
• Cost of capital
• The returns of other possible investments or projects.

Question 29

How can risk premiums be used in conjunction with hurdle rates?

Answer 29

Often, a risk premium is assigned to a potential investment to denote the anticipated amount of risk involved. The higher the risk, the higher the risk premium should be, as it takes into consideration the fact that if the risk of losing your money is higher, so should the return on your investment be higher. A risk premium is typically added onto the WACC to arrive at a more appropriate hurdle rate.

Using a hurdle rate to determine an investment’s potential helps eliminate any bias created by preference toward a project. By assigning an appropriate risk factor, an investor can use the hurdle rate to demonstrate whether the project has financial merit regardless of any assigned intrinsic value.

Question 30

What are the disadvantages of using a hurdle rate?

Answer 30

Hurdle rates typically favour projects or investments that have high rates of return on a percentage basis, even if the dollar value is smaller. Additionally, choosing a risk premium is a difficult task as it is not a guaranteed number. A project or investment may return more or less than expected and if chosen incorrectly, this can result in a decision that is not an efficient use of funds or one that results in missed opportunities.