Time Value of Money
Why is money worth more today than it is next year?
Because you could invest that money today and earn something with it by next year.
What does the “Discount Rate” mean?
The Discount Rate represents your opportunity cost or your “targeted yield.”
The Discount Rate represents both the potential returns and the risk of other, similar opportunities.
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)
$200 / (10% – 4%) = $3,333
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.
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.
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.
Stock market varies a lot = riskier
Debt = fixed amounts of interest every year w/ high certainty
What might cause a company’s Present Value (PV) to increase or decrease?
A company’s Present Value might increase if:
• Future cash flows expected to increase
• Future cash flows expected to grow at faster rate
• Its “opportunity cost,” or Discount Rate, decreases because it lost access to certain investments
A company’s Present Value might decrease if:
•Future cash flows expected to decrease
• Future cash flows expected to grow at slower rate.
• Its “opportunity cost,” or Discount Rate, increases because it gained access to better investment opportunities
What impacts the IRR of a project, investment, or company?
The expected future cash flow and cash flow growth rate, the Asking Price of a company or investment and the expected selling price of that company or investment.
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?
What is WACC?
“Weighted Average Cost of Capital,” and it’s the most common Discount Rate used to value companies.
= (Discount Rate x % Allocation) + (Discount Rate x % Allocation)
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
You would also review the qualitative and market factors and make sure that all of those support your decision as well.
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.
An investment’s IRR might decrease if:
• Its expected future cash flows decrease.
• Its future cash flows are expected to grow at a slower rate.
• Its expected selling price in the future decreases.
• Its “Asking Price” increases.
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.
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.
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.
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.
The WACC of the company as a whole doesn’t matter – what matters is that the IRR in this specific region and division exceeds WACC for this same region and division.
If the Present Value of an investment is $1,000 and the Asking Price is $800, then what is its Net Present Value?
$200.
How much would you pay for a company that generates $100 of cash flow every single year into eternity?
Estimate for a targeted yield of 10%.
For a targeted yield of 20%.
The formula is Company Value = Cash Flow / Discount Rate
10% = $1000
20% = $500
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 for the investment.
Why is valuation more complex than looking at a company’s cash flows, cash flow growth rate, and an appropriate Discount Rate?
1) There are many different types of “cash flow,” and no one can agree on exactly how to calculate it. It also takes quite a bit of effort to move from a company’s financial statements to its cash flow.
2) The Discount Rate is tricky to estimate, it might change over time, and you might use a different Discount Rate depending on the type of cash flow.
3) It takes time and effort to estimate a company’s cash flow growth; to do that, you often have to build a more complex financial model.
4) “company value” is not so simple because it depends on which investors and which parts of the company you’re including.