Basic Finance
Basic Finance Concepts
• Earnings and Cash Flow
• The Time Value of Money
• Present Value (PV)
• Internal Rate of Return (IRR)
Earnings vs. Cash Flow
In Accounting, people talk about earnings, because of the accrual accounting give
investor a better sense of a company’s profitability.
• Revenue is recognized when goods and services are delivered
• Cost is recognized when the it occurred
In Finance, people talk about cash flows, because CF is the real money return that the
company generated in a period of time
• Cash Flow Statement show the different between net income and cash from
operation
• We will talk about FCF in later slides
Time Value of Money
• The most important concept is that money today is worth MORE than money
tomorrow
• But, how much more is the question that we answer with Present Value
• For Example:
• Say you win the lottery and you have two payout options:
• Option 1: You collect a lump sum of $100,000 today
• Option 2: You collect $105,000 next year
• Which option do you chose and why?
Time Value of Money
• The most important concept is that money today is worth MORE than money
tomorrow
• But, how much more is the question that we answer with Present Value
• For Example:
• Say you win the lottery and you have two payout options:
• Option 1: You collect a lump sum of $100,000 today
• Option 2: You collect $105,000 next year
• Which option do you chose and why?
It depends on the discount rate because you have to analyze both of the numbers
based off of their present values
Present Value
• Present Value: Current value of a future sum of money given a specified rate of
return
• r is the discount rate and n is the time period
• Future Money must be discounted to its value today, or “present value”, when
analyzing it
Discount Rate
• Discount Rate: Refers to the interest rate used to determine present value
• See more on WACC in future session
• Could also be requity
• Or while investing in T-Bill, it is the risk free rate
• A higher Discount Rate means that the risk and potential returns are both
higher, and a lower discount Rate means that the risk and potential returns are
both lower.
• Same Cash Flow, Higher Discount Rate, Lower PV
Perpetuity
Perpetuity = stream of cash flows that continue forever
• Example: You receive $100 once a year every year forever
• CF = Cash flow
• r = discount rate
Growing Perpetuity
Growing Perpetuity: A growing perpetuity is a stream of cash flow that is expected
to be received every year forever but also grow at the same growth rate forever.
• C = Cash flow in year 1
• r = Discount rate
• g = Growth rate
Company Valuation
• A normal business is expected to generate CF each year, and CF is growing each
year
• But how many period? We can’t assume a normal company is going to go
bankrupt in a finite period of years, so we assume a company is generating CF
for ever
• Therefore, when valuing a company, we assume the company is a growing
perpetuity
Net Present Value (NPV)
• Net Present Value: Difference between the present value of cash inflows and the
present value of cash outflows over a period of time
• This is used in capital budgeting to analyze the profitability of a projected
investment or project
Internal Rate of Return (IRR)
• The internal rate of return (IRR) is a metric used in capital budgeting to estimate the
profitability of potential investments. The internal rate of return is a discount rate
that makes the net present value (NPV) of all cash flows from a particular project
equal to zero. IRR calculations rely on the same formula as NPV does.
• The IRR must be calculated either on excel or with a financial calculator, it is very
difficult to do the math
• In general, the higher a project’s IRR, the more desirable it is to undertake
• IRR is the rate of growth a project is projected to generate
Interviews
• It is unlikely that you will be asked a question on any of these concepts directly in an
interview
• However, having an understanding of each is very important because they come up
in other topics
• Present Value: DCF
• Discount Rates: WACC, CAPM
• IRR: LBOs
Interview Questions
Why is money worth more today than it is next year?
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.
Why is the Discount Rate higher for stock-market investments than it is for
debt investments, such as lending money to others?
Why is the Discount Rate higher for stock-market investments than it is for
debt investments, such as lending money to others?
• Because the risk and potential returns of stock-market investments are both higher.
Over the long term, you might earn an average of 10-11% per year in the stock
market. But in a given year, the market might fall by 30% or rise by 40%, so the
return each year varies tremendously. With debt, by contrast, you’ll earn a fixed
amount of interest every single year with a very high certainty
How much would you pay for a company that generates $100 of cash flow
every single year into eternity?
How much would you pay for a company that generates $100 of cash flow
every single year into eternity?
It depends on your Discount Rate, or “targeted yield. ”For example, if your targeted
yield is 10%, you’d pay $100 / 10%, or $1,000, for this company. But if your targeted
yield is 20%, you’d pay only $100 / 20%, or $500, for this company. If there’s no
growth, the formula is always the same: Company Value = Cash Flow / Discount
Rate.
What might cause a company’s Present Value (PV) to increase?
What might cause a company’s Present Value (PV) to increase?
• Its expected future cash flows increase.
• Its future cash flows are expected to grow at a faster rate.
• Our “opportunity cost,” or Discount Rate, decreases because we lose access to
certain investments.
What’s “Net Present Value”?
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.
• For example, if the Present Value of an investment is $1,000 and the Asking Price is
$800, then its Net Present Value is $200
