Core Finance Principles and Valuation

Vocabulary flashcards reviewing core corporate finance concepts including Opportunity Cost, Discount Rate, WACC, Present Value formulas, IRR, NPV, and Valuation principles.

Time Value of Money

The financial principle that money available today is worth more than the same amount in the future because money today can be invested to earn returns by next year.

Opportunity Cost

The potential return or yield foregone by choosing one financial option over another, such as the interest lost on extra capital paid upfront as a large deposit instead of invested elsewhere.

Discount Rate

A rate representing an investor's opportunity cost or targeted yield—the return that could be earned on capital in alternative, similar investments—reflecting both potential returns and risk.

Stock-Market vs. Debt Discount Rate

Stock-market investments carry a higher discount rate than debt investments (such as government bonds) because stocks have higher risk and annual return volatility, whereas debt provides fixed, highly certain interest returns.

Weighted Average Cost of Capital (WACC)

The most common discount rate used to value companies, representing the expected average annual return if an investor invested proportionally in both the debt and equity of a company over the long term.

WACC Calculation Formula

Calculated as $\text{WACC} = (\text{\% Equity} \times \text{Cost of Equity}) + (\text{\% Debt} \times \text{Cost of Debt})$ plus any other capital sources.

Company Value Formula (No Growth)

The formula used to value a firm generating constant annual cash flow into eternity: $\text{Company Value} = \frac{\text{Cash Flow}}{\text{Discount Rate}}$

Company Value Formula (With Cash Flow Growth)

The valuation formula when cash flow grows at a constant long-term rate: $\text{Company Value} = \frac{\text{Cash Flow}}{\text{Discount Rate} - \text{Cash Flow Growth Rate}}$ provided that Cash Flow Growth Rate is less than the Discount Rate.

Present Value (PV) Drivers

Factors impacting present value: PV increases when future cash flows or cash flow growth rates increase, or when the discount rate decreases. PV decreases when cash flows or growth rates drop, or when the discount rate increases.

Investment Decision Criteria

The financial rules of thumb stating an investment makes sense if its asking price is below its intrinsic value and its potential returns exceed the investor's opportunity cost.

Internal Rate of Return (IRR)

The effective compounded annual interest rate earned on an investment, or the exact discount rate at which the Net Present Value (NPV) of an investment equals 0.

Net Present Value (NPV)

The sum of an investment's discounted future cash flows (Present Value) minus its upfront asking price.

IRR Decision Rule

An evaluation rule stating that if an investment's IRR exceeds its WACC or discount rate, the project should be accepted; if IRR is less than WACC, it should be rejected.

Factors Influencing IRR

IRR is affected by expected cash flows, cash flow growth rate, asking price, and future selling price. The discount rate does NOT affect IRR because calculating IRR solves for the discount rate.

Project-Specific WACC Rule

When evaluating divisional or regional expansion projects, IRR must be compared against the WACC specific to that region and industry rather than the overall company WACC.

Valuation Complexities

Challenges in valuation resulting from multiple cash flow definitions, difficulty moving from financial statements to cash flow, changing discount rates over time, complex growth modeling, and varying scope of company value.