Overview of Basic Finance Concepts

• Key Topics:
  • Earnings and Cash Flow
  • Time Value of Money
  • Present Value (PV)
  • Internal Rate of Return (IRR)

Earnings vs. Cash Flow

• Earnings (Accounting Perspective):
  • Based on accrual accounting:
    • Revenue recognized when goods/services are delivered.
    • Costs recognized when incurred (matched to revenue).
  • Provides a smoothed, representative picture of profitability.
• Cash Flow (Finance Perspective):
  • Represents real money generated over time.
  • Highlighted in the Cash Flow Statement (CFS), showing the difference between net income and Cash from Operations.
  • More volatile and harder to interpret directly.
• Example: Prepaid Rent Expense:
  • Scenario: Company prepays $6,000 annual rent ($500/month) in January.
  • Cash Flow: $6,000 outflow in January, $0 thereafter.
  • Earnings: $500 expense each month (smoothed via accrual).
  • Prepaid Expenses (Asset): Starts at $5,500 in January, decreases by $500 monthly to $0 by year-end.
  • Insight: Accrual accounting evens out volatility for better analysis.

Time Value of Money (TVM)

• Core Principle: Money today is worth more than money tomorrow due to its potential to earn a return.
• Key Question: How much more? Answered using Present Value (PV).
• Example: Lottery payout options:
  • Option 1: $100,000 today.
  • Option 2: $105,000 in one year.
  • Decision depends on the discount rate (e.g., opportunity cost of investing today).

Present Value (PV)

• Definition: Current value of a future sum, discounted at a specified rate.
• Formula: \[ \text{PV} = \frac{\text{Future Value}}{(1 + r)^n} \]
  • \( r \): Discount rate (e.g., interest rate).
  • \( n \): Number of time periods.
• Discount Rate:
  • Reflects opportunity cost or risk:
    • Higher \( r \): Higher risk/return, lower PV.
    • Lower \( r \): Lower risk/return, higher PV.
  • Examples: WACC (Weighted Average Cost of Capital), equity return (\( r_{\text{equity}} \)), risk-free rate (e.g., T-Bills).
• Example #1: Lottery Payout:
  • Discount Rate: 8%.
  • Option 1: $100,000 today, PV = $100,000 (n = 0).
  • Option 2: $105,000 in 1 year, PV = $105,000 / (1 + 0.08)^1 = $97,222.
  • Choice: Option 1 (PV $100,000 > $97,222).

Perpetuity