Basic Finance + Questions

 Present Value:

  • Time value of money: money today is worth more than money tomorrow. Future money must be discounted to its value today, or the "present value." 
  • Present Value: the current value of a future sum of money given a specified rate of return
  • Present Value = Future Value / (1+r)^n
    • r = discount rate (expected rate of return on investment, think of it like opportunity cost)
    • n = time period
Discount Rate:
  • Refers to the interest rate used to determine the present value
  • Higher risk = higher returns = higher discount rate
  • Higher discount rate = lower present value
Perpetuity:
  • Stream of cash flows that continue forever
  • PV = CF / r
    • CF = cash flow
    • r = discount rate
Growing Perpetuity:
  • Stream of cash flow that is expected to be received every year forever but also grow at the same growth rate forever
  • PV = C / r - g
    • C = cash flow in year 1
    • r = discount rate
    • g = growth rate
Net Present Value (NPV):
  • Difference between the present value of cash inflows and the present value of cash outflows over a period of time, used in capital budgeting to analyze the profitability of a projected investment or project
Internal Rate of Return (IRR):
  • Estimates how much money you can make from an investment 
  • Higher IRR = more desirable investment 
Interview Questions:

Why is the Discount Rate higher for stock-market investments than it is for debt investments, such as lending money to others?

  • The risk and potential returns of stock market investments are both higher. Over the long term, you might earn an average of 10-11% in the stock market, but it 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 year with very high certainty
How much would you pay for a company that generates $100 of cash flow every single year into eternity?
  • Depends on discount rate
  • e.g. if discount rate = 10%, we'd pay $100/10%, or $1000, 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 PV to increase?
  • Lower discount rate
  • Expected future cash flows increase
  • Future cash flows are expected to grow at faster rate
What is Net Present Value?
  • Present value of an investment, i.e. sum of its discounted cash flows minus the "asking price," or what you pay up front for the investment
  • e.g. if PV of an investment is $1000 and the asking price is $800, NPV = 200


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