BIWS - Financial Modeling Fundamentals - PV, NPV, IRR, and the Discount Rate (WACC)

($ in Thousands USD, £ in Millions GBP)

The Discount Rate and Weighted Average Cost of Capital (WACC)

Your "opportunity cost" - what could you earn by investing elsewhere?

Stocks: Tends to be higher because expected, potential returns are higher. Stock's price could double or triple! No real limit.

Bonds / Debt: Tends to be lower because you're (mostly) limited to interest.

Intuition: Do you think a 3% government bond will make you more money than the stock market, over the long-haul? Of course not.

BUT: Also a lot more fluctuation and volatility in the stock market! Might go up 20%, then down 50%, up 30%...

Real Life: How are you investing your money? Or how do you plan to invest it?

Method: Opportunity Cost (Discount Rate):

Do Nothing, Leave It in a Checking Account: 0.1% Or maybe just 0.0%?

High-Yield Savings Account: 1.0% Depends greatly on interest rates.

Bonds / Loans to Friends, Companies, etc.: 5.0% Depends greatly on interest rates.

Stock Market Investments: 10.0% ~11% average in US over ~100 years.

Question: What is your "opportunity cost"? If you get a check for $1,000, how much could you earn on that in the future?

It depends on how you allocate that $1,000 to the different possibilities above. Here's an example of your "personal WACC":

Method: Discount Rate: Allocation:

Do Nothing, Leave It in a Checking Account: 0.1% 35.0%

High-Yield Savings Account: 1.0% 30.0%
Bonds / Loans to Friends, Companies, etc.: 5.0% 20.0%
Stock Market Investments: 10.0% 15.0%

Your Personal "WACC": 2.8%

Why not put everything in the stock market? Because of the much higher risk! You might lose all your money… yes, over the long-term
it may increase by an average of 10%, but in individual years it might be down by 20%, or up by 50%, or down/up by other %'s.

For companies, it's very similar… but there are different options, and it's more dependent on their investors (AKA, you and others).

Source of Funding: After-Tax Discount Rate: % Total Funding:

Equity (Selling stock in the company to investors): 10.0% 60.0%

Debt (Borrowing money from others): 5.0% 40.0%

Company WACC: 8.0%

These figures will depend on the company's size, stability, the interest rate it pays on its borrowings, and how volatile its stock is
relative to the rest of the market… more "ups and downs" = investors will have greater expectations for returns to compensate them.
Present Value, Net Present Value, and How to Use Them with the Discount Rate

QUESTION: Is a house / stock / bond expensive? Or is it cheap?

Depends… is it worth more or less than its intrinsic value - the present value of its future cash flows.

Let's say that we have an opportunity to BUY that same apartment in Korea from the last lesson for $200K… and then sell it in 5 years.

QUESTION: Is $200K a good price for the apartment? Is it really worth more or less than that?

"Asking Price" (Initial Investment): $ 200

Annual Cash Flow from Rent Extracted from Poor Tenants: 12
Apartment Sale Value: 200
Our Opportunity Cost ("Discount Rate"): 2.8%

Cash Flows: Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

Rental Income: $ 12 $ 12 $ 12 $ 12 $ 12
Property Sale: - - - - 200
Net Cash Flows: $ 12 $ 12 $ 12 $ 12 $ 212

Present Value (PV): $ 229

Should We Invest? Yes

What Could Change Our Decision Here? Good question…

1. Apartment Sale Value Falls - Oops! Could easily happen, real estate prices go up and down.

2. Apartment Stays Vacant for Some Time - If it takes too long to find tenants, might ruin the numbers.

3. Our Opportunity Cost Changes - If we get some incredible new opportunity, this one might not be worth it.

4. Asking Price Changes - If the current owner suddenly wants more, this might turn into a bad idea.

And it's exactly the same with companies:

1. Apartment Sale Value Falls - Company might be worth less in the future!

2. Apartment Stays Vacant for Some Time - Company's cash flows decrease or collapse.

3. Our Opportunity Cost Changes - Other companies / investments promise better returns.

4. Asking Price Changes - Stock price of company, or price that owner wants, suddenly changes.
The Internal Rate of Return (IRR) and How to Use It

Another type of Discount Rate, similar to WACC… but we solve for this one. We don't know it in advance!

"Asking Price" (Initial Investment): $ 200

Annual Cash Flow from Rent Extracted from Poor Tenants: 12
Apartment Sale Value: 200
Our Opportunity Cost ("Discount Rate"): 2.8%

Cash Flows: Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

Rental Income: $ 12 $ 12 $ 12 $ 12 $ 12
Property (Purchase) / Sale: (200) - - - - 200
Net Cash Flows: $ (200) $ 12 $ 12 $ 12 $ 12 $ 212

Internal Rate of Return (IRR): 6.0%

Should We Invest? Yes

Interpretation 1: If we invested $200K and earned 6% on it each year, compounded annually, we'd get the equivalent of
the cash flows shown above. "The effective compounded interest rate on an investment."

Interpretation 2: Another way to evaluate investments / projects: Will you earn more than you would with other opportunities?

Interpretation 3: The IRR is the Discount Rate at which the NPV equals $0 - remember, NPV is like Present Value but you
also have to subtract the initial investment… Excel NPV function does not do this, so it's very confusing!

Cash Flows: Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

Rental Income: $ 12 $ 12 $ 12 $ 12 $ 12
Property Sale: - - - - 200
Net Cash Flows: $ 12 $ 12 $ 12 $ 12 $ 212

Net Present Value (NPV): ($0.00)

Your Exercise: Help Sir Richard Branson Invest His Money!

Task: Virgin, the British multinational conglomerate, was founded by Sir Richard Branson and owns ventures across a huge array of
industries (travel, entertainment, lifestyle, financial services, transportation, healthcare, food and beverages, media/telecom, etc.).

Should they go to Jupiter, or stay back on Earth and seek out greater fortunes there? Or do both? Up to you!

Virgin Galactic: Considering purchasing a fleet of new space shuttles that can take wealthy tourists to Jupiter and back.

Virgin Asia: Considering an order of aircraft for a new, low-cost airline servicing East and Southeast Asia.

Virgin - Assumptions and WACC by Division: WACC:

Virgin - Entire Company: 10.0%

Virgin Galactic: 15.0%
Virgin Asia: 8.0%

Initial Investment Required for Jupiter Fleet: £ 1,000

Annual Cash Flows Earned from Trips to Jupiter: 100
Resale / Long-Term Value of Fleet Beyond Year 5: 1,200

Cash Flows from Jupiter Fleet: Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
Cash Flows from Jupiter Trips: £ - £ 100 £ 100 £ 100 £ 100 £ 100
Fleet (Purchase) / Sale: (1,000) - - - - 1,200
Net Cash Flows: -£ 1,000 £ 100 £ 100 £ 100 £ 100 £ 1,300

Internal Rate of Return (IRR): 13.1%

Initial Investment Required for Virgin Asia Aircraft: £ 400

Annual Cash Flows Earned from Virgin Asia: 30
Resale / Long-Term Value of Aircraft Beyond Year 5: 450

Cash Flows from Virgin Asia: Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
Cash Flows from Virgin Asia: £ - £ 30 £ 30 £ 30 £ 30 £ 30
Aircraft (Purchase) / Sale: (400) - - - - 450
Net Cash Flows: -£ 400 £ 30 £ 30 £ 30 £ 30 £ 480

Internal Rate of Return (IRR): 9.6%

CONCLUSIONS: Do the Virgin Asia deal because the project-specific IRR beats the project-specific WACC. But don't
do the Virgin Galactic expansion because the project-specific IRR is lower than the project-specific WACC.

WACC of entire company doesn't matter unless it's a project, acquisition, or expansion that affects the entire company.