Core Concepts Flashcards
True or False: Companies tend to grow at slower rates as they get bigger.
True.
What is financial modeling?
Financial modeling allows you to estimate the value of a company by quantifying your views on the company. The output of the model allows you to make better decisions (i.e.: if your an investment banker, you might use a financial model to advise clients on what they should do, etc.).
True or False: Money today is worth more than money tomorrow. Justify your answer
True.
Money earned/received today can be invested/used to earn more money in the future. (Also, maybe inflation).
What is opportunity cost? How do you use opportunity cost to make investment decisions? What is another name/term for opportunity cost in the finance world?
How much you could earn elsewhere with/from other similar investments.
If the potential returns from an investment exceed your opportunity cost, you invest; if not, then you do not invest.
Discount rate. (or also cost of capital)
What are the two main ways to make/assess investment decisions?
- Is the asking price (of the asset, company, etc.) below the intrinsic value? If so, invest.
- Does an asset’s potential returns exceed your opportunity cost? If so, invest.
What is Present Value?
What an asset’s or company’s future cash flows are worth today. The Present Value of future cash flows is often referred to as the “intrinsic value” or “implied value” of a company or asset.
Why do discount rates matter? What does a higher discount rate indicate?
Discount rates represent your opportunity cost (the potential returns and risk of other, similar opportunities) or your “targeted yield” and allow you to calculate Present Value.
A higher discount rate indicates higher risk and potential returns.
What are the two main funding sources for companies? Briefly explain each funding source and which is more expensive/cheaper.
Equity and Debt.
Equity means the company raises money by selling stock to investors. In exchange, investors will own a small percentage of the company. Equity is almost always the most expensive way to fund its operations (because the investor expects a higher rate of return because of increased risk and lower priority than debt-holders if the company liquidates).
Debt means the company raises money by borrowing from its lenders. The lenders do not own any portion of the company, but they receive interest payments and get their entire principal back in the future. Debt is less expensive (because less risky, gets paid back first, interest-tax shield)
Provide examples of risky and less risky industries.
Risky: Biotech
Less Risky/More Mature: Manufacturing
What is IRR?
The Internal Rate of Return (IRR) is a type of discount rate. It is the effective, compound interest rate on an investment. It is the discount rate at which NPV equals $0.
You can solve for the IRR if you have an upfront investment (“asking price”) and a series of cash flows.
What is NPV? What is the associated rule of thumb for deciding whether or not to invest?
Present Value of Cash Flows Discounted at WACC - Upfront Investment (“Asking Price”)
If NPV > 0, then invest (because the PV of CF Discounted at WACC > Asking Price).
True or False: If IRR > WACC, then Asking Price < Present Value and you should invest.
True.
What is WACC?
The Weighted Average Cost of Capital (WACC) is the most common discount rate for companies/used to value companies. 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.
It is based on the percentage of equity the company is using times the cost of equity plus the percentage of debt the company is using times the (after-tax) cost of debt (plus the same items for any other capital sources).
The cost for the company to raise its next dollar.
What is a company worth? What is its intrinsic value
A company is worth the sum of its discounted cash flows, from now into eternity, discounted at a rate that’s appropriate for the company’s business risk, size, industry, and mix of equity and debt.
The appropriate rate is the discount rate or the yield you’re targeting.
True or False: If a company generates higher cash flow, you will be willing to pay more for it.
True.
