400Q Generalist Technical Questions

pg 46-49

What does the “Discount Rate” mean?

The Discount Rate represents the opportunity cost of investing in a company. In other words, if you don’t invest in this company, how much could you earn over the long term by investing in other companies?

Essentially, it represents the potential returns and the risk of other similar companies.

If the Discount Rate is higher, both potential returns and risks are hihger, and vice versa.

Why is the Discount Rate higher if the potential returns are higher? Shouldn’t a company with higher potential returns have a lower Discount Rate, making it more valuable?

No, an increase in potential returns also means an increase in potential risks. It’s more risky to invest in a company that could provide a 10x return compared to a company that has a 2x return.

The point is is that there’s no “free lunch”. Higher returns equal higher risks.

What is WACC?

WACC stands for “Weighted Average Cost of Capital”, the most common discount rate for valuing companies. 

To calculate it, you multiply that % equity of the company’s total capital structure by the cost of equity, multiply the % debt of the total capital structure by the cost of debt, and add them up. 

WACC represents the average annualized return you’d expect to earn if you invested in the Debt AND Equity of a company and held them long term.

How much would you pay for a company that generates $100 of cash flow every single year into enternity/perpetuity? 

Compnay value = Final Cash Flow / (Discount Rate - Final Cash Flow growth)

However, if the cash flow doesn’t grow at all, it’d be Final Cash Flow / Discount Rate.

So, if your Discount Rate, or “targeted yield,” is 10%, you’d pay $1000 as it’s $100/10%.

A company generates $100 of cash flow today, and its cash flow is expected to grow at 5% per year for the long term.

You could earn 10% per year by investing in other, similar companies. How much would you pay for the company?

Company Value = Cash Flow / (Discount Rate - Cash Flow Growth Rate)

100/ (10% - 5%) = $2000

A higher discount rate makes a company less valuable, and a higher cash flow growth rate makes a company more valuable.

What does “Present Value” mean, and what makes it change? How does it differ from Net Present Value?

The Present Value (PV) of an asset or company equals its future cash flows discounted at the appropriate Discount Rate.

The PV tells you what a company or asset is worth today based on its potential future performance and your returns expectations.

The PV increases if the company’s epected future cash flow or growth rate increases OR the discount rate decreases, and vice versa for the PV decreases.

“Net Present Value” means that you take the PV of these future cash flows and subtract the upfront cost or “asking price” of the compnay.

If NPV is positive, the company is worth more than its current price.

What does the internal rate of return (IRR) mean? How do you calculate it?

Technically, the IRR represents the Discount Rate at which the NPV of an investment equals 0.

Basically, you can think of it as “the effective compounded rate of return on an investment.”

To calculate IRR, you can enter the upfront investment as negative in Excel and the future cash flows and sale value as positive and apply the IRR function to that whole range.

What affects the IRR? How do these factors differ from the ones that affect the Present Value?

Many factors are the same: Higher cash flows, growth rates, or future sale values for the asset increase both the Present Value and the IRR. Lower values for these assumptions reduce both the Present Value and the IRR.

One major difference is that the Discount Rate does NOT affect the IRR - because you are solving for the Discount Rate when you calculate the IRR.

The whole point of the IRR calculation is that you can compare the IRR to the Discount Rate to see whether the investment is worth your time and money.

Another major difference is that the “asking price” affects the IRR since it’s entered as a negative for the first value of the series, but it doesn’t impact the Present Value.

You should compare the Present Value to this upfront price to see if the investment is worth more or less than its price. 

How do you use the IRR, Discount Rate, and Present Value to make investment decisions?

Normally, you calculate the IRR and compare it to the Discount Rate of a project, investment, or company.

If the IRR exceeds the Discount Rate, investing makes sense, and vice versa if it doesn’t.

Compare the Present Value to the upfront price does the same thing: if the PV of the future cash flows exceeds this upfront price, invest; otherwise, don’t invest.

Present Value of $1000 in 5 years at 10% discount rate?

1000 / (1 + 0.10)^5