Net Present Value
The cornerstone of finance is the concept of Net Present Value (NPV). Essentially, a dollar today is worth more than a dollar in the future. Using NPV, we can discount future cash - say from a project or investment - to determine the value today.
Example: Assuming an 8% discount rate, or cost of capital, an investment that costs $100 today that will yield $50 at the end of the next three years has an NPV =
-$100 + $50/(1+8%)^1 + $50/(1+8%)^2 + $50/(1+8%)^3 = $28.85.
Since the NPV is positive, we should invest in the project.
When building a Discounted Cash Flow (DCF) model to value a company, as we do in our financial modeling course, we are using NPV to discount to today's value the future cash flows the company will generate.
Internal Rate of Return
The project above has an NPV greater than zero when the discount rate is 8%. Let's say we wanted to determine the discount rate that would make the NPV = 0.
In Excel, we can use Goal Seek to set the NPV to 0 by changing the discount rate.
Data > What-If Analysis > Goal Seek
Setting the NPV to 0 by changing the discount rate yields a value of 23.4%. The 23.4% represents the IRR of the investment, or the time-weighted/average return.
We can also use the IRR function and we'll get the same 23.4%. Since 23.4% is greater than our 8% cost of capital, we should invest in the project (we arrive at the same conclusion as the NPV method).
IRRs are especially useful when evaluating Leveraged Buyouts and bond investments (the bond yield is an IRR).
When you think of the word finance, what likely comes to mind is car financing, or financing a home purchase, etc. Car or home financing is simply how one plans to pay for those purchases.
Finance is how companies pay to make investments (like capital improvements, acquisitions, etc.) and maintain daily operations. The cheapest source of capital, or money, is cash on hand, or cash generated from the ongoing operations of the business. However, many companies need additional cash, and this is where debt and equity financing comes into play.
Debt financing includes loans from a bank or bond offering (see below for more detail on bonds). When taking on debt financing, a company borrows money and promises to repay the principal (original borrowed amount) and interest. The interest rate can be fixed or variable (based on certain interest rate benchmarks like LIBOR), and the principal must be repaid on the maturity date (some debt financing allows for early repayment without penalty - it varies). Debt financing is a cheaper source of capital than equity because of its senior position - debtholders must be paid before equity holders.
With debt financing the cheaper alternative, why would companies look at equity financing? And what exactly is equity financing? When a company raises by issuing equity, it is selling shares to investors for cash it can use to finance its operations and investments. The existing shareholders now own less of the company, but the company has the cash it needs to execute its plan.
Companies can raise equity through private or public issuances. Let's start with the widely-known Initial Public Offering or IPO. In an IPO, a company sells its shares for the first time to the public, meaning anyone can buy the shares. The shares trade on exchanges and can be bought and sold easily (increased "liquidity"). After an IPO, companies can sell additional shares to the public in what is called a Secondary Offering. Companies can raise equity on the private markets, often through venture capitalists or angel investors.
Another form of financing is preferred stock, which is a hybrid of debt and equity. Preferred stock has a fixed interest rate like debt, but the maturity date is often long or perpetual, giving it an equity-like risk profile. Preferred stockholders are not entitled to the same dividend or voting rights as stockholders.
We discussed how companies can raise capital by issuing equity, or stock, and now we'll discuss how they can raise capital through debt offerings.
What are bonds?
A bond is a debt instrument issued by a borrower that pays interest until the principal is due at maturity.
A bond has several characteristics. The principal amount is the total amount due at the maturity date. Bonds typically pay coupons or interest payments or more throughout the year. For example, if a bond pays interest quarterly, its annual coupon is paid over four periods throughout the year.
Types of bonds
- There are several types of bonds including government bonds, municipal bonds, and corporate bonds.
- Government bonds are issued by national governments and are generally less risky, thereby carrying a lower yield.
- Municipal bonds, or “Muni Bonds”, are issued by local or state governments to fund infrastructure projects, schools, and other public projects. Muni Bonds often either state or federal tax-exempt or both, meaning that the interest earned on these bonds carry lower effective tax rates.
- Corporate bonds are issued by companies to fund their daily operations and to finance investments or acquisitions. Corporate bonds are broken into investment-grade bonds and junk or speculative bonds. An investment-grade bond carries a Moody's rating of Baa3 or higher, or BBB- for S&P. High-yield bonds (or junk bonds) carry ratings below those thresholds.