Financial Modeling Basics: Time Value, IRR, WACC, Valuation

Key Rule #1: What “Financial Modeling” Really Means (Without the Textbook Nonsense)

The Story: You, Your Opinion, and That One Overconfident Friend

Picture this:

You and your overly caffeinated, overly confident friend are sitting in a coworking space arguing about a company’s stock price.
The stock trades at $150 today.

You think it’s worth $210.
Your friend thinks it’s more like $90.

Classic stalemate.
Like arguing whether pineapple belongs on pizza.

So who’s right?

Neither of you… yet.
Because opinions don’t matter. Numbers do.

And that’s where a financial model comes in.

So What Is a Financial Model Really?

Not the Excel labyrinth you’ve seen online.
Not the 72-tab monster your future VP brags about creating at 3 AM.

Think of a model like this:

A financial model = a decision-making blueprint.

It’s not the entire skyscraper…
It’s the architectural drawing that tells you if the building will stand or collapse before you waste money on concrete.

It tells you:

• Where the business makes money
• Where it bleeds money
• How much cash it might generate
• And ultimately whether you’re about to make a genius move… or light money on fire

Your Model vs. Your Friend’s Model

Let’s say you plug in the numbers for your company:

• It historically grows revenue at 10%
• But to justify a $210 share price, your model requires 32% annual growth

Your friend does his version:

• He thinks revenue grows at 5%
• And that supports a $90 share price

Who’s “right”?

Neither. But one of you is less wrong.

Companies don’t magically triple their growth rate just because your spreadsheet thinks it would be nice.

A slowdown from 10% → 5% is believable.
A jump from 10% → 32% is… well… good luck.

So your friend has the stronger argument here.
Not because he’s smarter, but because his assumptions actually align with how real companies behave.

Why We Build Models (The Real Reason, Not the Textbook Answer)

You build a model because money is at stake.

Here’s where modeling shows up in real life:

1. Stock Investing

The market nukes a cloud-software company’s stock by 40% overnight.
Is it:

• A bargain? or
• A flaming garbage fire?

Your model answers that.

2. Mergers & Acquisitions (M&A)

A big logistics company wants to acquire a smaller competitor.
You need to figure out:

• Does the acquisition make the acquirer richer?
• Or is it like buying a fancy treadmill and never using it?

A model tells the truth.

3. Private Equity / LBO Deals

PE investors want to buy a food manufacturer, cut unnecessary fat, and sell it in 4–6 years.

They don’t ask,
“Is this business inspiring?”

They ask:
“Can we hit our target IRR without blowing ourselves up?”

A model answers that.

4. Corporate Decision-Making

Even inside Fortune 100 companies, CFOs ask:

• Should we open 50 new stores?
• Should we shut down an unprofitable division?
• Should we issue debt or equity?

Every one of those decisions runs through a model first.

The 6-Step Process (In Real People Language)

No fancy jargon. No MBA fluff.

Step 1: Know the Point of the Model

Are you trying to:

• Prove the stock is undervalued?
• Show whether a merger works?
• Decide whether buying a business produces the return you need?

If you don’t know the goal, your model becomes a spreadsheet amusement park.

Step 2: Do Background Research

Read filings, earnings calls, industry reports.
Learn what the company actually does — the number of candidates who skip this step would shock you.

Step 3: Identify the Key Drivers

Every industry has 3–5 big levers that matter.

Examples:

• Airlines: flights, load factor, revenue per passenger
• SaaS: subscription price, churn, customer growth
• Retail: number of stores, revenue per store, margins
• Biotech: patients, pricing, R&D expense intensity

Everything else is noise.

Step 4: Gather Comparable Data

Just like buying a house:
You check what similar homes sold for.

Same with companies.

Step 5: Build the Model

Forecast:

• Revenue
• Expenses
• Cash flows

Then tie everything together.

This ranges from 30 minutes → several months, depending on how much your boss hates you.

Step 6: Present the Story

This is where most interview candidates die.

A model is NOT the story.
A model SUPPORTS the story.

You end with something simple like:

• “Buy this company for $420M; it creates value.”
• “This stock is worth $96; it trades at $52; we should buy.”
• “This deal fails to meet our return threshold — walk away.”

Simple. Clear. Punchy.

The Big Picture Takeaway

Financial modeling isn’t about Excel wizardry.
It’s not about 18 layers of formulas.

It’s about quantifying a story so your decisions aren’t emotional—they’re logical.

A model does one job:

It helps you avoid looking stupid when real money is on the line.

Key Rule #2: The Time Value of Money – Why $100 Today Always Beats $100 Next Year

Imagine someone offers you this choice:

“You can take $10,000 today, or $10,000 exactly two years from now.”

If you hesitate, you need caffeine or a finance reboot.

You always take the money today.

Not because “inflation” is some cartoon villain chasing your dollars around — though it does help your case.
The real reason is simpler:

Money today can be invested.
Money tomorrow cannot.

If you get $10,000 today, you can invest it, earn a return, and turn it into more than $10,000 by the time “future you” shows up.

The Real-Life Housing Decision: Large Deposit vs. Monthly Rent

Let’s use an example you might actually face in the U.S.

You’re choosing between two apartment rental options:

Option A – Large Deposit, Zero Monthly Rent

• Pay an upfront $50,000 deposit
• Pay no monthly rent
• Get the entire $50,000 back in 2 years

Option B – Small Deposit, Monthly Rent

• Pay just $5,000 deposit
• Pay $2,500 per month
• Get the $5,000 back in 2 years

Most people say:

“Choose Option A. You’re not losing anything — you get the full deposit back!”

That sounds nice, but it’s financially incomplete.

Here’s the real issue:

• Option A forces you to lock away an extra $45,000
• That money cannot be invested or used for anything productive during those 2 years
• Your “return” from Option A is simply… no rent

But with Option B:

• You keep the extra $45,000
• Yes, you pay rent — $2,500 × 12 = $30,000 per year
• But you can invest the $45,000 and earn a return

So this becomes a simple question:

“Can I earn more than $30,000 per year by investing the extra $45,000 I keep under Option B?”

Let’s test it.

• If you earn 5% per year on $45,000 → you make $2,250 per year
  (Clearly not enough to offset rent.)
• If you earn 15% per year in high-risk investments → $45,000 × 15% = $6,750 per year
  (Still far below $30,000 rent.)
• If rent were lower or your returns higher, the calculation could flip in the opposite direction.

The math is not the key — the framework is:

Compare what you get here vs. what you could earn somewhere else with the same amount of money and similar risk.

Present Value: Turning Future Dollars Into Today’s Dollars

Now we introduce Present Value (PV).

Future money isn’t worth the same as today’s money.

If you’ll receive $50,000 in two years, what is that worth today?

It depends on your opportunity cost — what you could earn elsewhere.

Example:

If your opportunity cost = 10% per year

PV = $50,000 / (1 + 10%)²
≈ $41,322 today

Reason:

• $41,322 × 1.10 = $45,454
• $45,454 × 1.10 = $50,000

If your opportunity cost = 2% per year

PV = $50,000 / (1.02)²
≈ $48,038 today

Same $50,000 in the future — different PVs today.

Time Value of Money In One Sentence

Money today is worth more than money tomorrow because you can invest it today and earn a return.

Everything in DCF, valuation, and financial modeling comes from this one sentence.

Key Rule #3: PV, NPV, IRR, and WACC – The 4 Tools That Run Every Finance Decision

Now we take the concepts from above and translate them into the four acronyms:

• PV – Present Value
• NPV – Net Present Value
• IRR – Internal Rate of Return
• WACC – Weighted Average Cost of Capital

They’re the entire language of:

• Valuation
• Deal analysis
• Capital budgeting
• Private equity
• Corporate finance
• Everything an analyst touches

The Discount Rate: The Official Term for “Your Best Alternative Return”

When we say:

“Discount these cash flows at 9%.”

We really mean:

“If I don’t invest in this, I can reasonably earn around 9% elsewhere for similar risk.”

Higher discount rate =
You demand more return because your alternatives are better or risk is higher.

Lower discount rate =
You’re willing to accept less return because alternatives are weaker or risk is lower.

From Personal Investing to Corporate Financing: Enter WACC

People spread their money among:

• Cash (maybe 1–2%)
• Bonds (4–6%)
• Stocks (7–10%+ long-term)

A company does something similar.
Its “portfolio” is made of:

• Equity (expensive — shareholders expect high returns)
• Debt (cheaper — interest rates are lower)

So a company calculates the blend:

WACC = % Equity × Cost of Equity + % Debt × Cost of Debt

Example:

• Equity: 60% @ 10% expected return
• Debt: 40% @ 5% interest rate

WACC = 0.6 × 10% + 0.4 × 5% = 8%

This tells investors:

“If you invest in this company’s equity and debt in proportion, your long-term blended return expectation is about 8%.”

Using WACC to Value an Investment (Apartment Example)

You’re evaluating a $200,000 apartment investment:

• Annual cash flow (net rent) = $12,000 per year
• Resale value in year 5 = $200,000
• Opportunity cost / discount rate = 2.8%

You discount:

• Each year’s $12,000
• The final $200,000

…back to today and get:

• Present Value ≈ $212,000

Since PV > $200,000:

“This works — on paper.”

If the seller suddenly asks for $260,000?

PV < Asking Price → Don’t buy it.

NPV & IRR: Two Perspectives, Same Outcome

Net Present Value (NPV)

NPV = PV of Cash Flows – Initial Investment

• If NPV > 0 → good
• If NPV < 0 → walk away

Using the above example:

• PV = $212,000
• Price = $200,000
• NPV = +$12,000

Internal Rate of Return (IRR)

IRR is the implied annual compounded return of the investment.

If cash flows are:

• Year 0: −$200,000
• Years 1–4: +$12,000
• Year 5: +$212,000

Excel IRR() returns about 6%.

Interpretation:

“This deal behaves like earning 6% per year, compounded.”

Since 6% > 2.8% (your opportunity cost):

“It’s attractive.”

Why IRR and NPV Always Agree

If:

• NPV > 0 at a certain discount rate

It automatically means:

• IRR > that discount rate

And vice-versa.

They’re two expressions of the same relationship:

“Do these cash flows beat my required return?”

Real Corporate Example

A conglomerate considers two expansions:

• Space Tourism Division
  • Division WACC: 15%
  • Project IRR: 14%
• Low-Cost Airline in Southeast Asia
  • Division WACC: 8%
  • Project IRR: 10%

Which should it choose?

• Space: IRR (14%) < WACC (15%) → Reject
• Airline: IRR (10%) > WACC (8%) → Accept

This is the rule:

Always compare IRR against the project-specific WACC, not the corporate average.

Key Rule #4: How to Value Any Company – The Simplest (and Most Important) Formula

Here’s the truth that investment banking loves to complicate:

A company is worth the Present Value of all the cash it will generate in the future.

If a company generates $100 of cash per year, forever, and your required return is 10%, then:

Value = $100 / 10% = $1,000

If your required return is 20%, the value is:

$100 / 20% = $500

Same business.
Different required return → different valuation.

Add Growth to the Picture

If cash flow grows:

• Cash Flow today: $100
• Growth: 3% forever
• Required return: 10%

Use the growing perpetuity formula:

Value = Cash Flow / (Discount Rate – Growth)

Value = $100 / (10% – 3%) = $100 / 7% ≈ $1,429

Higher growth → higher valuation.
Higher discount rate → lower valuation.

Real-World Complication: Growth Changes, Risk Changes

Companies don’t grow at:

“3% forever.”

They grow:

• Faster early
• Slower later
• Then stabilize

Their risk changes too:

• Young companies → higher discount rate
• Mature companies → lower discount rate

This is why we use a DCF:

DCF Structure:

1. Explicit Forecast Period (5–10 years)
   • Detailed projections
2. Terminal Value
   • Apply the formula:
     CF₁₁ / (Discount Rate – Terminal Growth)
3. Discount Everything To Today
4. Add It Up → Intrinsic Value

If intrinsic value > market price → undervalued.
If intrinsic value < market price → overvalued.

Mini Example

Suppose after all calculations the DCF gives:

• Intrinsic Value = $1,770

If the stock trades at:

• $1,200 → undervalued → buy
• $2,200 → overvalued → avoid or short (carefully)

That’s all a DCF is:
Forecast → discount → sum → compare price.

Key Rule #5: Why Financial Modeling Is Hard (Even Though the Formula Is Easy)

If valuation is so simple…

Why do analysts sit in offices at 3 AM eating stale protein bars and adjusting cell references?

Because all the input pieces in the simple formula are messy.

1. No One Agrees on “Cash Flow”

You’ll hear:

• EBITDA
• Unlevered Free Cash Flow (FCFF)
• Levered Free Cash Flow (FCFE)
• Operating Cash Flow
• Adjusted FCF
• Recurring FCF
• Owner’s earnings

None of these are identical.

You must rebuild cash flow manually from the financial statements — and every firm does it differently.

2. Growth Isn’t Just “Let’s Assume 5%”

Real modeling requires:

• Revenue drivers
• Customer counts
• Pricing
• Volumes
• Churn
• Margins
• Operating leverage
• Capital expenditures
• Working capital cycles

Growth is an output, not a lazy assumption.

3. Accounting Isn’t Cash

Income Statement ≠ Cash Flow.

Balance Sheet ≠ Cash Flow.

You must:

• Remove non-cash items
• Adjust for working capital
• Subtract capital expenditures
• Add back only what’s appropriate

This is why 3-statement modeling is a huge part of finance training.

4. “Value” Has Multiple Definitions

Two main categories:

• Equity Value – for shareholders
• Enterprise Value – for all capital providers

You must always match:

• Correct type of cash flow
• Correct discount rate
• Correct valuation metric

Mix them up, and the model is wrong even if your math is perfect.

5. Sometimes You Care About IRR, Not Value

For example:

Private Equity (LBO)

• You ask: “What IRR do we get if we buy and sell in 5 years?”
• Focus shifts from intrinsic value to returns.

Debt Capacity

• You ask: “Can the company pay interest and principal under stress scenarios?”

Corporate Budgeting

• “Does this project outperform our hurdle rate?”

These aren’t pure valuation questions.

How the Rest of Financial Modeling Fits Together

Everything else in the course exists to solve these practical realities:

• Turning accounting into cash flow
• Estimating growth
• Estimating discount rates
• Understanding enterprise value vs equity value
• Modeling M&A, LBOs, debt, equity raises
• Handling working capital, capex, taxes, depreciation

The underlying principles are simple — the execution is what’s hard.

Interview Questions

1. Why is money worth more today than next year?

Because money today can be invested and earn a return.
Money next year cannot.

2. If there’s no inflation, is money today still more valuable?

Yes.
Even without inflation, you can:

• Invest it
• Earn interest
• Start a business or project

You still earn something, so money today > money tomorrow.

3. Choosing between a large deposit + no rent vs. small deposit + monthly rent. How decide?

Compare:

• What you save in rent, vs.
• What you could earn by investing the extra money you keep

If you can earn more with that extra cash than the rent costs → choose lower deposit + rent.
If not → choose higher deposit + no rent.

4. Your friend says his new investment makes 10% per year. Should you invest?

Only if:

• The risk matches other options
• You can’t earn more than 10% elsewhere

Return alone is meaningless.
Return relative to alternatives of similar risk is what matters.

5. What is the Discount Rate?

Your:

• Required return
• Opportunity cost
• Target yield

It reflects what you could earn on other investments with similar risk.

6. Why is the Discount Rate higher for stocks than government bonds?

Stocks:

• Higher expected return
• Higher volatility
• Higher risk
  → higher Discount Rate

Government bonds:

• Lower return
• Lower risk
  → lower Discount Rate

7. What is WACC?

Weighted Average Cost of Capital.

The blended return that both debt and equity investors expect to earn.

8. If WACC = 8%, what does that mean?

If you invest proportionally in the company’s equity + debt, you should expect to earn ~8% per year on average over the long run.

9. Company generates $100 per year forever. Required return = 10%. Value?

$100 ÷ 10% = $1,000

10. Company generates $200 of cash flow today growing at 4%. Required return = 10%. Value?

$200 / (10% − 4%) = $200 / 6% ≈ $3,333

11. What causes Present Value to rise?

• Higher expected cash flows
• Faster cash flow growth
• Lower discount rate (worse alternatives elsewhere)

Decline?

• Lower expected cash flows
• Slower growth
• Higher discount rate (better alternatives elsewhere)

12. How decide whether to invest?

You invest when:

• Asking Price < Intrinsic Value
• IRR > Discount Rate

13. What is IRR?

The effective annual compounded return of an investment.

Also the discount rate at which NPV = 0.

14. What is NPV?

NPV = PV of cash flows − initial investment.

Positive NPV → you beat your required return.

15. How do you use IRR?

Calculate IRR and compare to your Discount Rate / WACC.

If IRR > WACC → invest.

16. What increases or decreases IRR?

IRR increases when:

• Cash flows increase
• Growth increases
• Exit/sale value increases
• Purchase price decreases

IRR decreases when:

• Cash flows decrease
• Growth slows
• Sale value decreases
• Purchase price rises

17. Project IRR is 10%. Division WACC is 8%. Companywide WACC is 11%. Should they do it?

Yes.

Always compare IRR vs. division/project-specific WACC.

18. Why is valuation hard?

Because:

• Cash flow definitions vary
• Accounting ≠ cash flow
• Discount rates are complex
• Growth assumptions are hard
• Enterprise Value vs Equity Value matters
• Many situations care about IRR, not value