Reference

The Internal Rate of Return (IRR) is a financial metric used to assess the attractiveness of an investment opportunity. It represents the discount rate that makes the net present value (NPV) of a series of cash flows equal to zero. In simpler terms, the IRR tells you the compound annual growth rate an investment is expected to generate. For example if the IRR of the initial cash outlay and subsequent years cash inflows is 9%, this is the rate used in NPV calculations to show an NPV of zero for the same cash flows.

Higher IRR: Generally considered more attractive, indicating a potentially higher return on investment.

Short and Long Positions: Trading the Market's Ups and Downs

In financial markets, taking a long position or a short position signifies your bet on the future price movement of an asset. These are fundamental concepts for investors and traders:

Long Position:

• Buying an asset (stock, currency, etc.) with the expectation that its price will increase.

• You own the asset and aim to sell it later at a higher price to profit from the difference.

• Often associated with a bullish outlook on the market or specific asset.

Short Position:

• Borrowing an asset and then selling it with the expectation that its price will decrease.

• You don't actually own the asset initially, but you have an obligation to buy it back later to return it to the lender.

• You profit if the price goes down because you can buy it back cheaper and pocket the difference.

• Often associated with a bearish outlook on the market or specific asset.

• Short selling involves more complexity and risks than long positions. It requires a margin account and carries the potential for unlimited losses.

Here's an example of a short selling position:

Imagine you're an investor who believes the stock price of "TechCo" is overvalued. The current price is $50 per share. You think negative news is about to be released, causing the price to drop. Here's how you could take a short position:

• Borrow 100 shares of TechCo from your broker. You don't own these shares, but you have an obligation to return them later.

• Sell the borrowed shares for $50 each, collecting $5,000. This is your initial investment.

• Wait for the price of TechCo to drop. Let's say the negative news hits, and the price falls to $30 per share.

• Buy back 100 shares of TechCo at $30 each, spending $3,000. You now have repurchased the borrowed shares and returned them to your broker.

• Pocket the profit of $2,000 ($5,000 - $3,000). This is your gain from the short position.

WACC represents the average cost of capital a company requires to finance its operations, considering both debt and equity sources. In simple terms, it tells you how much you, as a company, need to pay to attract investors and lenders to fund your activities.

WACC = Cost of Equity * % Equity + Cost of Debt * (1 – Tax Rate) * % Debt + Cost of Preferred Stock * % Preferred Stock

The Cost of Equity represents potential returns from the company’s stock price and dividends, or how much it “costs” the company to issue shares.

For example, if the company’s dividends are 3% of its current share price (i.e., the dividend yield is 3%), and its stock price has increased by 6-8% each year historically, its Cost of Equity might be between 9% and 11%.

The Cost of Debt represents returns on the company’s Debt, mostly from interest, but also from the market value of the Debt changing.

For example, if the company is paying a 6% interest rate on its Debt, and the market value of its Debt is close to its face value, then the Cost of Debt might be around 6%.

You also multiply that by (1 – Tax Rate) because Interest paid on Debt is tax-deductible. So, if the Tax Rate is 25%, the After-Tax Cost of Debt would be 6% * (1 – 25%) = 4.5%.

The Cost of Preferred Stock is similar because Preferred Stock works similarly to Debt, but Preferred Stock Dividends are not tax-deductible, and overall rates tend to be higher, making it more expensive.

The Discount Rate in Real Life vs. Simple Approximations

The calculations for the Cost of Debt and Preferred Stock are straightforward, but the Cost of Equity is more challenging because it’s subjective and depends on how other, similar companies have performed relative to the market.

In many DCF models, you’ll see a sheet dedicated to this calculation, where the modeler “un-levers Beta” for each peer company to estimate its risk/volatility independent of its capital structure and then re-levers it for the subject company.

A “shortcut method” as well, which involves using the same formula but simplifying the last input:

Cost of Equity = Risk-Free Rate + Equity Risk Premium * Levered Beta

The Risk-Free Rate (RFR) is what you might earn on “safe” government bonds in the same currency as the company’s cash flows (so, U.S. Treasuries here).

The Equity Risk Premium (ERP) is the percentage the stock market is expected to return each year, on average, above the yield on these “safe” government bonds.

And Levered Beta tells you how volatile this stock is relative to the market as a whole, factoring in both business risk and risk from leverage (Debt).

If it’s 1.0, then the stock follows the market perfectly and goes up by 10% when the market goes up by 10%; if it’s 2.0, the stock goes up by 20% when the market goes up by 10%.

Rather than finding comparable companies and un-levering and re-levering Beta, you could just look it up for the company on Yahoo Finance:

Both swaps and options are financial instruments but they function differently:

Swaps:

Definition: A swap is a customized agreement between two parties to exchange cash flows based on different underlying assets or financial instruments.

Key features:

• Over-the-counter (OTC) market: Not traded on exchanges, directly negotiated between parties.

• Customized contracts: Tailored to specific needs, not standardized like options.

• Exchange of cash flows: One party pays a fixed rate, while the other pays a variable rate (e.g., interest rate swap).

Common types of Swaps: Interest rate swaps, currency swaps, commodity swaps, equity swaps.

Purpose: Hedging risks, managing exposures, speculating on future movements.

Options:

Definition: An option gives the holder the right, but not the obligation, to buy or sell an underlying asset at a specific price (strike price) on or before a specific date (expiration date).

Call | Option to buy i..e  If you expect the price to rise, you can pay a premium, and exercise the option to buy if the price does rise (or sell the call option) prior to expiration

Put | Option to sell i..e  If you expect the price to fall, you can pay a premium, and exercise the option to sell if the price does fall (or sell the call option) prior to expiration

Key features:

• Exchange-traded or OTC: Options on certain assets trade on exchanges, while others are OTC.

• Standardized contracts: Have preset terms like strike price and expiration date.

• Right, not obligation: The holder can choose to exercise the option or let it expire worthless.

Two types: Call options (right to buy) and put options (right to sell).

Purpose: Speculating on price movements, hedging existing positions, generating income (selling options).