1
00:00:00,000 --> 00:00:18,000
The Illinois State Collegiate Compendium, Academic Lecture in Business and Economics.

2
00:00:18,000 --> 00:00:29,300
This is Business Finance, FIL 240 for Autumn semester 2023.

3
00:00:29,300 --> 00:00:31,800
Today, Forecasting Cash Flow.

4
00:00:31,800 --> 00:00:35,400
As I said, we will have a surprise quiz on Wednesday.

5
00:00:35,400 --> 00:00:40,800
It will have a few different exciting components.

6
00:00:40,800 --> 00:00:50,120
And I do want to bring up one quick, couple of last points about weighted average cost

7
00:00:50,120 --> 00:00:51,500
of capital.

8
00:00:51,500 --> 00:00:56,040
The quiz will be primarily on that.

9
00:00:56,040 --> 00:01:00,760
And then this week is Forecasting Cash Flows.

10
00:01:00,760 --> 00:01:05,840
And then we go into special topics.

11
00:01:05,840 --> 00:01:11,640
And then it's over, a few special topics, and then it's over with.

12
00:01:11,640 --> 00:01:15,760
And the dream that has been this class will end.

13
00:01:15,760 --> 00:01:17,360
Or something like that.

14
00:01:17,360 --> 00:01:18,940
Now here we go.

15
00:01:18,940 --> 00:01:21,200
The numbers for the day.

16
00:01:21,200 --> 00:01:25,280
And it is a rather odd day on the street.

17
00:01:25,280 --> 00:01:34,080
Not sure how to explain it, but you've got a sort of a tepid market.

18
00:01:34,080 --> 00:01:35,660
They're all positive.

19
00:01:35,660 --> 00:01:37,240
But there was a drop.

20
00:01:37,240 --> 00:01:39,600
And I'm not sure what spooked the markets.

21
00:01:39,600 --> 00:01:47,140
As you can see, the Dow and the S&P 500 and the NASDAQ were all up and then they went

22
00:01:47,140 --> 00:01:48,760
down and up.

23
00:01:48,760 --> 00:01:52,480
And then they all dipped into negative territory for a while.

24
00:01:52,480 --> 00:01:55,840
For about an hour or so, hour and a half.

25
00:01:55,840 --> 00:01:57,600
And then they came back up again.

26
00:01:57,600 --> 00:01:59,240
But that's barely anything.

27
00:01:59,240 --> 00:02:05,040
Dow is up a lousy four hundredths of a percent.

28
00:02:05,040 --> 00:02:08,720
S&P 500 is not much better.

29
00:02:08,720 --> 00:02:09,720
Six hundredths of a percent.

30
00:02:09,720 --> 00:02:16,200
And the Dow, or rather the NASDAQ, is up.14 percent.

31
00:02:16,200 --> 00:02:21,040
It's just not an exciting day on the street at all.

32
00:02:21,040 --> 00:02:26,760
And what that means, it's kind of hard to say.

33
00:02:26,760 --> 00:02:32,920
But interestingly enough, crude oil had a bull surge and then it dropped back down to

34
00:02:32,920 --> 00:02:33,920
about 81.

35
00:02:33,920 --> 00:02:38,520
It's still below the trading range that it had established, 82 to 88.

36
00:02:38,520 --> 00:02:44,640
But the price of gasoline has suddenly gone up at the pump.

37
00:02:44,640 --> 00:02:51,720
Most likely because the supply of gasoline is being sacrificed somewhat to get more of

38
00:02:51,720 --> 00:02:53,920
the distillates into the market.

39
00:02:53,920 --> 00:02:55,720
But it's kind of hard to say.

40
00:02:55,720 --> 00:02:57,760
Now here's the interesting part.

41
00:02:57,760 --> 00:03:00,160
The 10-year bond.

42
00:03:00,160 --> 00:03:07,560
The yield is up, or rather, yeah, the yield is up so the price is down.

43
00:03:07,560 --> 00:03:14,160
Now that surge in the yield kind of doesn't mean great things for the economy.

44
00:03:14,160 --> 00:03:16,180
It's not a disaster or anything.

45
00:03:16,180 --> 00:03:20,640
But you've got the yields are up, which means prices are down, which means that investors

46
00:03:20,640 --> 00:03:22,880
are getting out of bonds.

47
00:03:22,880 --> 00:03:28,920
And over here, they're not putting that money into equities at all.

48
00:03:28,920 --> 00:03:31,700
So it looks like money is going to the sideline.

49
00:03:31,700 --> 00:03:36,280
Looking at the activity on the S&P 500, oh yeah, look at that.

50
00:03:36,280 --> 00:03:37,280
Very weak activity.

51
00:03:37,280 --> 00:03:43,440
Remember last week we were beginning to see numbers in the upper two billions.

52
00:03:43,440 --> 00:03:47,400
And now we're back down there.

53
00:03:47,400 --> 00:03:51,400
It's probably not going to even have half of the average daily volume.

54
00:03:51,400 --> 00:03:58,680
So like I said, that's money pulling off the markets, the bonds, and the stocks, and just

55
00:03:58,680 --> 00:04:04,480
going back into cash to kind of hold on and wait to see what happens next.

56
00:04:04,480 --> 00:04:06,760
You know, who knows?

57
00:04:06,760 --> 00:04:13,800
It's difficult to say what will make the markets happy again, but it's nothing big.

58
00:04:13,800 --> 00:04:18,000
Give me a brief moment here.

59
00:04:18,000 --> 00:04:20,040
I'll look at the other ones.

60
00:04:20,040 --> 00:04:25,720
Gold's down, so there's no fear of a crisis in the economy.

61
00:04:25,720 --> 00:04:29,000
The gold bugs are bailing out again.

62
00:04:29,000 --> 00:04:33,200
But oddly, well, that's interesting because the euro had appreciated.

63
00:04:33,200 --> 00:04:43,600
As a matter of fact, the pound and the euro both appreciated, and then they fell back

64
00:04:43,600 --> 00:04:46,480
down to depreciate.

65
00:04:46,480 --> 00:04:51,080
Well that would probably be because those yields on the bonds, US bonds were pulling

66
00:04:51,080 --> 00:04:54,580
upward a little bit, making the dollar stronger.

67
00:04:54,580 --> 00:04:57,040
But it's really all over the place.

68
00:04:57,040 --> 00:05:03,400
Although the euro does seem to have gained some ground, it's up to about $1.07 right

69
00:05:03,400 --> 00:05:04,680
now.

70
00:05:04,680 --> 00:05:05,680
Hard to say though.

71
00:05:05,680 --> 00:05:12,720
Over here on the other side of the world, here's another day when the Nikkei had a blast

72
00:05:12,720 --> 00:05:17,000
right off the bat, and then it just floated on that.

73
00:05:17,000 --> 00:05:23,700
That was a two and a third percent rise in the Nikkei, all at the opening pretty much,

74
00:05:23,700 --> 00:05:25,360
and then it just floated.

75
00:05:25,360 --> 00:05:32,440
So something is getting the investors to jump in at the beginning, and then spend the rest

76
00:05:32,440 --> 00:05:35,640
of the day just staring at the market.

77
00:05:35,640 --> 00:05:37,480
Kind of hard to say, but there's one again.

78
00:05:37,480 --> 00:05:40,540
It has been showing so much volatility lately.

79
00:05:40,540 --> 00:05:47,040
If you've been watching this with me, that bouncing around has been just sort of like

80
00:05:47,040 --> 00:05:49,040
what it's been doing.

81
00:05:49,040 --> 00:05:50,560
Sort of like our market did.

82
00:05:50,560 --> 00:05:58,320
It was down, then up, then down, and sort of like what ours was doing somewhat too.

83
00:05:58,320 --> 00:06:04,580
Just a lot of volatility, but no direction on where it wants to go.

84
00:06:04,580 --> 00:06:09,040
Looking around the markets just for a few minutes here, just to see and to remind you

85
00:06:09,040 --> 00:06:12,240
of some of the things that we do here.

86
00:06:12,240 --> 00:06:15,040
Looking at bank stocks.

87
00:06:15,040 --> 00:06:17,160
Citi.

88
00:06:17,160 --> 00:06:20,160
Citi Group.

89
00:06:20,160 --> 00:06:21,480
Big huge bank.

90
00:06:21,480 --> 00:06:24,720
Down for the day, not spectacularly.

91
00:06:24,720 --> 00:06:29,940
Highly volatile, but it's just been in negative territory through the day.

92
00:06:29,940 --> 00:06:31,520
Not a happy sight at all.

93
00:06:31,520 --> 00:06:37,720
Now if you look at the P-E ratio, undervalued, but boy is that a risky stock.

94
00:06:37,720 --> 00:06:44,760
This is one of those 10 too big to fail banks, and that thing is really a risky stock.

95
00:06:44,760 --> 00:06:50,320
Looking quickly just to remind you about how to do this in case I ask it on the final exam

96
00:06:50,320 --> 00:06:53,000
or something like that.

97
00:06:53,000 --> 00:07:04,080
What you have here is we would take the 49.48, this is a projected one year holding period

98
00:07:04,080 --> 00:07:13,520
return divided by the current price one year before you sell it, 4205 minus one, and then

99
00:07:13,520 --> 00:07:25,040
you add that nice fat dividend yield, 4.92%.

100
00:07:25,040 --> 00:07:27,040
Let's try that again.

101
00:07:27,040 --> 00:07:28,640
49.48.

102
00:07:28,640 --> 00:07:30,640
Try it again.

103
00:07:30,640 --> 00:07:47,880
49.48 divided by 4204 minus one plus the dividend yield 4.92, oh I forgot, that's what the problem

104
00:07:47,880 --> 00:07:53,640
is, times, I forgot to, times the result by 100.

105
00:07:53,640 --> 00:07:56,440
Oh that's not bad.

106
00:07:56,440 --> 00:08:05,720
Times 100 plus the dividend yield 4.92%, and you get a nice, actually that's a decent return

107
00:08:05,720 --> 00:08:06,720
on Citibank.

108
00:08:06,720 --> 00:08:10,400
It's risky, I mean don't get me wrong about that.

109
00:08:10,400 --> 00:08:20,320
That's a 22.62% total holding period return, capital gain and dividend yield, but you're

110
00:08:20,320 --> 00:08:29,040
taking a risk on that at that 1.55, although it does seem to be undervalued right now.

111
00:08:29,040 --> 00:08:35,120
So if you're into bank stocks, that's a bank stock that would see, that at least is projected

112
00:08:35,120 --> 00:08:38,200
to earn a darn decent return.

113
00:08:38,200 --> 00:08:49,520
Turning to some other industry, let me think about, fast and all.

114
00:08:49,520 --> 00:08:54,160
I bring this up because I've had a surprising number of students who've gotten jobs with

115
00:08:54,160 --> 00:08:58,600
this company, and I'm not sure what it is about it.

116
00:08:58,600 --> 00:09:02,120
It's down hard today, really hard.

117
00:09:02,120 --> 00:09:10,480
It's got a beta of 1.11 PE ratio, it's pretty much valued appropriately, and it's EPS, it's

118
00:09:10,480 --> 00:09:14,560
a profitable company, but that return looks lousy.

119
00:09:14,560 --> 00:09:17,560
Let me try it.

120
00:09:17,560 --> 00:09:31,640
Divide it by, that would be the projected one year price, divide it by 58.69 minus one,

121
00:09:31,640 --> 00:09:38,240
then multiply the result by 100, then add that dividend 2.34%.

122
00:09:38,240 --> 00:09:40,760
This is a dog.

123
00:09:40,760 --> 00:09:43,480
3.43% return.

124
00:09:43,480 --> 00:09:51,560
It's above average risk too, so you can see that this is not a, shall we say, a prospective

125
00:09:51,560 --> 00:09:52,560
investment.

126
00:09:52,560 --> 00:09:58,480
It's not a, it's something to get really excited about putting your money into.

127
00:09:58,480 --> 00:10:07,040
But going to the wild side here, just to have a look at MSFT, Microsoft, might as well look

128
00:10:07,040 --> 00:10:15,800
at one of the behemoths of the earth, it's up about.83, 8.84%.

129
00:10:15,800 --> 00:10:25,600
It's got a low beta, it's slightly overvalued, projected for one year from now at 370.22,

130
00:10:25,600 --> 00:10:33,120
370.22 divided by an initial investment one year previous.

131
00:10:33,120 --> 00:10:36,120
Let's try this again.

132
00:10:36,120 --> 00:10:37,120
Wow.

133
00:10:37,120 --> 00:10:38,120
Okay.

134
00:10:38,120 --> 00:10:52,720
Looking at it again, let's try 370.22 divided by the current price one year before the sell

135
00:10:52,720 --> 00:11:04,600
of 355.83 minus one, and then multiply the result times 100, and then add the dividend,

136
00:11:04,600 --> 00:11:09,800
which is a lousy dividend, dividend yield,.85.

137
00:11:09,800 --> 00:11:13,440
Oh, that's not a great return.

138
00:11:13,440 --> 00:11:22,000
Of course, again, it's below one, so lower risk, lower expected return, but 4.89% isn't

139
00:11:22,000 --> 00:11:25,760
spectacular, not really spectacular.

140
00:11:25,760 --> 00:11:31,760
One of the reasons is the dividend yield on Microsoft is really not that great.

141
00:11:31,760 --> 00:11:39,520
It's just a.85% dividend yield, so what to say about that would be hard to tell.

142
00:11:39,520 --> 00:11:46,920
Well, it's nothing great.

143
00:11:46,920 --> 00:11:51,480
Let me take you off this for a little bit.

144
00:11:51,480 --> 00:11:54,560
I'm going to pull something up here.

145
00:11:54,560 --> 00:12:02,920
Let me go in, just so you are aware of how to do, because on the quiz I'm going to do

146
00:12:02,920 --> 00:12:08,440
a weighted average cost of capital problem, so getting one of those, you want to get to

147
00:12:08,440 --> 00:12:16,160
your WAC, weighted average cost of capital.

148
00:12:16,160 --> 00:12:17,160
I can find it.

149
00:12:17,160 --> 00:12:18,440
I couldn't find it.

150
00:12:18,440 --> 00:12:23,080
There it is.

151
00:12:23,080 --> 00:12:33,680
Note it.

152
00:12:33,680 --> 00:12:39,720
And you get, that's not the one I want.

153
00:12:39,720 --> 00:12:44,120
That is so not the one I want.

154
00:12:44,120 --> 00:12:48,120
Where is the one that I want?

155
00:12:48,120 --> 00:12:51,920
I'm not seeing it.

156
00:12:51,920 --> 00:13:00,680
I might not do this because it seems to have disappeared.

157
00:13:00,680 --> 00:13:03,680
How did it get there?

158
00:13:03,680 --> 00:13:15,720
Let me try and see if this is the one.

159
00:13:15,720 --> 00:13:18,200
It's the one that's got the pricing in it.

160
00:13:18,200 --> 00:13:20,560
That's not it either.

161
00:13:20,560 --> 00:13:23,960
I wonder where it is.

162
00:13:23,960 --> 00:13:30,160
It was WACC1, and I'm not seeing it anywhere in the files.

163
00:13:30,160 --> 00:13:32,040
Did you click on the spreadsheets?

164
00:13:32,040 --> 00:13:33,200
Yeah, let me do that.

165
00:13:33,200 --> 00:13:38,440
I did do that the first time, and I just wanted to see if it had migrated somehow up to the

166
00:13:38,440 --> 00:13:40,360
higher level.

167
00:13:40,360 --> 00:13:41,840
Spreadsheets.

168
00:13:41,840 --> 00:13:44,480
There it is.

169
00:13:44,480 --> 00:13:48,520
Whoa, I've got to stop.

170
00:13:48,520 --> 00:13:50,960
My coffee's getting too strong for me.

171
00:13:50,960 --> 00:13:58,160
Let me show you this now.

172
00:13:58,160 --> 00:13:59,160
There it is.

173
00:13:59,160 --> 00:14:06,000
Ah, I was going to say I spent way too much time on this for that to happen.

174
00:14:06,000 --> 00:14:12,920
Now all you're going to do, all you need to do is let's say, well I'll put in another

175
00:14:12,920 --> 00:14:13,920
example.

176
00:14:13,920 --> 00:14:23,760
Preferred, wait.

177
00:14:23,760 --> 00:14:26,680
Let's take one, it'll look very similar to this.

178
00:14:26,680 --> 00:14:32,480
Preferred, let's say it has a 3.2% dividend.

179
00:14:32,480 --> 00:14:40,240
Par value is, take any number you want, let's say $110 a share.

180
00:14:40,240 --> 00:14:46,840
It's currently priced at $75 a share.

181
00:14:46,840 --> 00:14:52,760
$75.25 per share.

182
00:14:52,760 --> 00:14:54,360
And the common stock.

183
00:14:54,360 --> 00:14:59,400
Now the way you notice it in the book, they gave you problems where they were telling

184
00:14:59,400 --> 00:15:02,000
you next year's dividend.

185
00:15:02,000 --> 00:15:05,980
It doesn't matter, all you have to do is put in the numbers correctly.

186
00:15:05,980 --> 00:15:11,080
But I will frame it so that you have the dividend that has just been paid.

187
00:15:11,080 --> 00:15:14,600
Let's say $2.50.

188
00:15:14,600 --> 00:15:24,080
It's expected to grow at let's say 4.5% per year.

189
00:15:24,080 --> 00:15:31,920
And the current price of it is let's say $38.45 per share.

190
00:15:31,920 --> 00:15:32,920
$28.

191
00:15:32,920 --> 00:15:35,800
No, let's do higher price.

192
00:15:35,800 --> 00:15:43,040
Let's do $35.51 per share.

193
00:15:43,040 --> 00:15:52,120
Bond price, let's say the bond price is right now $105.30 on the $100.

194
00:15:52,120 --> 00:15:57,320
And I'll give it to you on the $100 for the bond price so that you won't make the mistake

195
00:15:57,320 --> 00:16:01,320
up here.

196
00:16:01,320 --> 00:16:16,360
And then over here, par value of the company's bonds is let's say $15 million.

197
00:16:16,360 --> 00:16:28,080
Number of shares is $240,000.

198
00:16:28,080 --> 00:16:37,360
Number of shares authorized is let's say $30 million.

199
00:16:37,360 --> 00:16:47,360
And I also want to put in here with six years to maturity.

200
00:16:47,360 --> 00:16:58,920
And I will do what I can to parallel this wording on the quiz and on the exam where

201
00:16:58,920 --> 00:17:00,240
you'll get this stuff.

202
00:17:00,240 --> 00:17:08,720
Let me see if there's anything else I've forgotten.

203
00:17:08,720 --> 00:17:19,440
Okay, so now with the bonds.

204
00:17:19,440 --> 00:17:31,360
They're priced at par value of the bonds, market values.

205
00:17:31,360 --> 00:17:36,360
Let me get up here.

206
00:17:36,360 --> 00:17:41,960
Now the par value of the bonds, get those done first.

207
00:17:41,960 --> 00:17:52,640
I said five years or six years to maturity.

208
00:17:52,640 --> 00:17:55,720
Coupon is 4.25%.

209
00:17:55,720 --> 00:18:02,800
I'll just leave that 4.25.

210
00:18:02,800 --> 00:18:11,000
And they are at 105.30 on the $100.

211
00:18:11,000 --> 00:18:12,000
My ass.

212
00:18:12,000 --> 00:18:15,000
Price, 105.105.30.

213
00:18:15,000 --> 00:18:17,000
There.

214
00:18:17,000 --> 00:18:22,000
That's better.

215
00:18:22,000 --> 00:18:28,640
Okay, is that right?

216
00:18:28,640 --> 00:18:30,640
Six years to maturity.

217
00:18:30,640 --> 00:18:31,640
Yep.

218
00:18:31,640 --> 00:18:34,560
Okay, so we got that.

219
00:18:34,560 --> 00:18:36,600
Go over here and fix these up.

220
00:18:36,600 --> 00:18:39,200
We'll leave the tax rate at 21%.

221
00:18:39,200 --> 00:18:45,480
The cost of debt has been the preferred dividend is 3.2%.

222
00:18:45,480 --> 00:18:48,760
All right, 3.20%.

223
00:18:48,760 --> 00:18:55,640
Whoops, I didn't mean to do that there.

224
00:18:55,640 --> 00:19:10,120
4% par value of the preferred is $110.

225
00:19:10,120 --> 00:19:17,400
Current price is 75.25 up per share.

226
00:19:17,400 --> 00:19:24,760
Now where we share preferred shares outstanding, it's over here.

227
00:19:24,760 --> 00:19:32,520
240,000 shares.

228
00:19:32,520 --> 00:19:41,480
Common dividend is $250.

229
00:19:41,480 --> 00:19:59,080
Worth rate, 4.5% per year.

230
00:19:59,080 --> 00:20:17,520
The price of the common stock right now is $25.51 per share.

231
00:20:17,520 --> 00:20:19,200
That should be everything.

232
00:20:19,200 --> 00:20:33,680
Let me make sure, $15 million here.

233
00:20:33,680 --> 00:20:42,200
That one should be, oops, that's $15 million.

234
00:20:42,200 --> 00:20:46,880
Number of preferred shares outstanding is 240.

235
00:20:46,880 --> 00:20:48,640
I don't think I need that.

236
00:20:48,640 --> 00:20:52,000
I think I have it over there somewhere.

237
00:20:52,000 --> 00:21:03,720
But number of common shares is, how many common shares do they have outstanding?

238
00:21:03,720 --> 00:21:13,080
30 million.

239
00:21:13,080 --> 00:21:17,200
You don't need to worry about that new issue.

240
00:21:17,200 --> 00:21:21,520
That's irrelevant.

241
00:21:21,520 --> 00:21:28,600
Weighted average cost of capital should come out to be 14.27%.

242
00:21:28,600 --> 00:21:37,840
That's about all there is to it.

243
00:21:37,840 --> 00:21:42,640
You just got to fill in a lot of numbers, so I will give you more time, 20 minutes on

244
00:21:42,640 --> 00:21:45,120
the exam, on the quiz.

245
00:21:45,120 --> 00:21:49,120
Just because it's not calculating, it's just making sure you got all the numbers filled

246
00:21:49,120 --> 00:21:50,120
in.

247
00:21:50,120 --> 00:21:54,640
And that's how you do it.

248
00:21:54,640 --> 00:21:59,000
If you got that number, then you're in good shape.

249
00:21:59,000 --> 00:22:00,000
Notice something here.

250
00:22:00,000 --> 00:22:06,720
I should have scooted that over.

251
00:22:06,720 --> 00:22:11,120
They won't show you all the numbers, but they're okay.

252
00:22:11,120 --> 00:22:14,920
Anyway, that's how you do this problem.

253
00:22:14,920 --> 00:22:20,560
You just look at the numbers, you fill in all these little tables here, and once you've

254
00:22:20,560 --> 00:22:26,080
filled in all the tables with the numbers that you are given, the weighted average cost

255
00:22:26,080 --> 00:22:32,560
of capital will come out on its own.

256
00:22:32,560 --> 00:22:36,640
And you can try a few yourself just to make sure that you can do it.

257
00:22:36,640 --> 00:22:44,400
Just tweak the numbers around and see what happens to the weighted average cost of capital.

258
00:22:44,400 --> 00:22:47,040
That will be most of it.

259
00:22:47,040 --> 00:22:51,800
One other thing I want to help make sure that you know about.

260
00:22:51,800 --> 00:22:59,440
It's graphical, but I expect that you will need to know it for the quiz and or the final

261
00:22:59,440 --> 00:23:00,440
exam.

262
00:23:00,440 --> 00:23:04,360
I'm going to draw something on the board here.

263
00:23:04,360 --> 00:23:10,720
I drew it before, but I want to make sure that you know that one of those things is

264
00:23:10,720 --> 00:23:17,160
actually a serious point.

265
00:23:17,160 --> 00:23:18,160
Let me show you something.

266
00:23:18,160 --> 00:23:31,400
Matter of fact, nope, I already got, oh well, I could have shown it to you with that graph.

267
00:23:31,400 --> 00:23:42,320
The percent of debt in the capital structure versus the weighted average cost of capital.

268
00:23:42,320 --> 00:23:50,520
Now you remember the weighted average cost of capital is the weight of debt in the portfolio

269
00:23:50,520 --> 00:24:10,560
times the after-tax cost of debt plus the weight of equity times the cost of equity.

270
00:24:10,560 --> 00:24:23,600
Now if I were to draw the weighted average cost of capital, if I have no debt in the

271
00:24:23,600 --> 00:24:36,680
portfolio, then the weight of debt, no debt, then the weight of debt would be zero times

272
00:24:36,680 --> 00:24:48,680
the after-tax cost of debt plus 100% times the cost of equity.

273
00:24:48,680 --> 00:24:52,320
If there's no debt, then it's all equity.

274
00:24:52,320 --> 00:25:05,040
So if there is 0% debt, then the weighted average cost of capital is the cost of equity.

275
00:25:05,040 --> 00:25:21,040
If the company is all debt, that would mean the weighted average cost of capital is 100%

276
00:25:21,040 --> 00:25:40,240
times the cost of debt plus zero times the cost of equity.

277
00:25:40,240 --> 00:25:41,240
Gasp.

278
00:25:41,240 --> 00:25:49,600
Oh, like that helped anything?

279
00:25:49,600 --> 00:26:16,600
So if we're a 100% debt company, then we would have just the pure after-tax cost of

280
00:26:16,600 --> 00:26:25,680
debt, like somewhere here.

281
00:26:25,680 --> 00:26:35,520
So the weighted average cost of capital curve should look something like this.

282
00:26:35,520 --> 00:26:44,720
As you accumulate, use more debt and less equity, at first debt is cheaper than equity,

283
00:26:44,720 --> 00:26:47,760
so you have a declining curve.

284
00:26:47,760 --> 00:26:53,720
But eventually you start getting so much debt that the default premium, new debt, starts

285
00:26:53,720 --> 00:26:58,720
to hit hard and it starts to rise again.

286
00:26:58,720 --> 00:27:02,800
This is called the bottom.

287
00:27:02,800 --> 00:27:12,080
The lowest point is called the optimal capital structure.

288
00:27:12,080 --> 00:27:20,080
The optimal capital structure is the combination of debt and equity that minimizes the weighted

289
00:27:20,080 --> 00:27:31,000
average cost of capital.

290
00:27:31,000 --> 00:27:36,040
Make sure you understand that little graph there.

291
00:27:36,040 --> 00:27:40,640
There are three points of interest.

292
00:27:40,640 --> 00:27:48,680
I will ask something about this on the quiz and on possibly on the final exam.

293
00:27:48,680 --> 00:27:56,880
You just have to know what that graph, what the meaning of that graph is, what those important

294
00:27:56,880 --> 00:28:11,960
places on the graph are, what they're called.

295
00:28:11,960 --> 00:28:16,400
Enough of that one.

296
00:28:16,400 --> 00:28:18,280
Okay.

297
00:28:18,280 --> 00:28:30,240
Now some new material just for you new material fans out there.

298
00:28:30,240 --> 00:28:32,680
As my markers are dying here.

299
00:28:32,680 --> 00:28:36,120
Let me see if I...

300
00:28:36,120 --> 00:28:38,960
There's another one.

301
00:28:38,960 --> 00:28:39,960
See if that one's any better.

302
00:28:39,960 --> 00:28:41,800
Oh, that one's good.

303
00:28:41,800 --> 00:28:42,800
Okay.

304
00:28:42,800 --> 00:28:46,840
Now, this lecture is about forecasting cash flows.

305
00:28:46,840 --> 00:28:50,120
This is how we...

306
00:28:50,120 --> 00:28:58,740
It has so many uses in corporate finance and in corporations in general.

307
00:28:58,740 --> 00:29:06,200
We need to know where we are going to go from here and what each project is going to do

308
00:29:06,200 --> 00:29:11,240
with how we go from now to the future.

309
00:29:11,240 --> 00:29:19,840
This is the basis of figuring out how we finance our new projects, what decisions we make with

310
00:29:19,840 --> 00:29:26,560
respect to issuing stock versus issuing debt and all of that.

311
00:29:26,560 --> 00:29:37,040
Projecting cash flows.

312
00:29:37,040 --> 00:29:44,400
Now this thing, what I'm doing here, overall we have to project the full cash flows of

313
00:29:44,400 --> 00:29:46,520
the corporation.

314
00:29:46,520 --> 00:29:53,840
But in the path to that, we need to find out whether projects are worth our time or not

315
00:29:53,840 --> 00:29:56,840
as go or no go.

316
00:29:56,840 --> 00:30:10,400
So the first thing we have to do is project analysis.

317
00:30:10,400 --> 00:30:13,400
Project analysis.

318
00:30:13,400 --> 00:30:15,240
Well, that's going to...

319
00:30:15,240 --> 00:30:16,400
We got a new project.

320
00:30:16,400 --> 00:30:18,560
It could be a new product.

321
00:30:18,560 --> 00:30:20,740
It could be a new machine.

322
00:30:20,740 --> 00:30:24,240
It could be a new location.

323
00:30:24,240 --> 00:30:27,840
A project can be a lot of things.

324
00:30:27,840 --> 00:30:31,680
There are two different kinds.

325
00:30:31,680 --> 00:30:39,400
There are expansion projects and there are replacement projects.

326
00:30:39,400 --> 00:30:46,560
Now I've gone through some of this before, somewhat informally, and here's where we hit

327
00:30:46,560 --> 00:30:50,320
it over the head directly.

328
00:30:50,320 --> 00:30:51,520
Expansion projects.

329
00:30:51,520 --> 00:30:53,840
You're going to bring in a new product.

330
00:30:53,840 --> 00:30:56,040
You're going to build a new factory.

331
00:30:56,040 --> 00:30:59,480
You're going to buy some more cars or trucks.

332
00:30:59,480 --> 00:31:02,400
It's an expansion of what you're doing now.

333
00:31:02,400 --> 00:31:07,160
You're going to build a new skyscraper, whatever.

334
00:31:07,160 --> 00:31:13,520
And with these expansion projects, well, let me go over here.

335
00:31:13,520 --> 00:31:14,520
Replacement.

336
00:31:14,520 --> 00:31:19,080
You're going to get rid of something and replace it with something else.

337
00:31:19,080 --> 00:31:22,320
Now there would be some reason you do that.

338
00:31:22,320 --> 00:31:28,760
Most likely, if you're going to do a replacement project, it's going to be replacing one machine

339
00:31:28,760 --> 00:31:34,640
with another, replacing an existing fleet of trucks with a new set of trucks, something

340
00:31:34,640 --> 00:31:41,000
along that line, or replacing one old building with another new building.

341
00:31:41,000 --> 00:31:46,680
But one way or the other, you are not looking at these two projects in the same way.

342
00:31:46,680 --> 00:31:56,080
This one is adding revenue.

343
00:31:56,080 --> 00:32:06,920
Incremental revenues.

344
00:32:06,920 --> 00:32:11,480
And as a consequence, incremental costs.

345
00:32:11,480 --> 00:32:16,020
Again, this is something I talked about before.

346
00:32:16,020 --> 00:32:18,360
We are sandboxing the project.

347
00:32:18,360 --> 00:32:25,280
All that we look at is what the new thing is going to do for us in terms of revenue

348
00:32:25,280 --> 00:32:26,920
and in terms of cost.

349
00:32:26,920 --> 00:32:40,400
With a replacement project, that is just an change, increment, or decrement in cost.

350
00:32:40,400 --> 00:32:47,200
Generally speaking, replacement will happen only if the increment is negative.

351
00:32:47,200 --> 00:32:49,680
In other words, if we're saving money.

352
00:32:49,680 --> 00:32:54,840
A new fleet of electric vehicles is going to cost us less than the existing fleet of

353
00:32:54,840 --> 00:32:59,560
diesel powered vehicles or gas powered vehicles, something along that line.

354
00:32:59,560 --> 00:33:04,800
The new building is going to be more energy efficient than the old building would be,

355
00:33:04,800 --> 00:33:08,560
something along that line.

356
00:33:08,560 --> 00:33:12,600
But it's an incremental cost almost exclusively.

357
00:33:12,600 --> 00:33:23,200
So in other words, in this one, you would have the old cost, new cost of let's say fuel,

358
00:33:23,200 --> 00:33:28,760
15,000 versus 12,000.

359
00:33:28,760 --> 00:33:39,240
So the increment is you are saving $3,000.

360
00:33:39,240 --> 00:33:43,440
But there's a cost upfront to doing that.

361
00:33:43,440 --> 00:33:45,200
So that's where we start.

362
00:33:45,200 --> 00:34:00,400
Now as far as these sandboxing and all this is concerned, focusing on expansion projects

363
00:34:00,400 --> 00:34:07,640
right now.

364
00:34:07,640 --> 00:34:14,640
The first thing is the upfront cost.

365
00:34:14,640 --> 00:34:17,880
The upfront investment as it were.

366
00:34:17,880 --> 00:34:24,520
What's it going to be?

367
00:34:24,520 --> 00:34:37,760
And then from there, the new revenues from the project.

368
00:34:37,760 --> 00:34:40,800
New revenue.

369
00:34:40,800 --> 00:34:58,880
And the new costs associated with generating that revenue.

370
00:34:58,880 --> 00:35:05,880
That's where we start.

371
00:35:05,880 --> 00:35:20,720
First things first, you look only at the new project.

372
00:35:20,720 --> 00:35:28,520
Don't look at it in the context of the company.

373
00:35:28,520 --> 00:35:38,080
However, you do have to watch out for two things.

374
00:35:38,080 --> 00:35:42,840
One is on the negative side, cannibalism.

375
00:35:42,840 --> 00:35:50,920
If it's a new product, is it going to take revenues from something we already have on

376
00:35:50,920 --> 00:35:52,000
the shelves?

377
00:35:52,000 --> 00:35:58,500
If it is, that is a subtraction from the new revenues.

378
00:35:58,500 --> 00:36:05,320
Most companies try their best not to cannibalize an existing product.

379
00:36:05,320 --> 00:36:09,000
Unless that project is in its decline phase.

380
00:36:09,000 --> 00:36:19,680
If you remember possibly from marketing or something like that, you have this introductory

381
00:36:19,680 --> 00:36:27,880
phase and then you have the growth phase and then the maturity phase and then the decline

382
00:36:27,880 --> 00:36:29,600
phase.

383
00:36:29,600 --> 00:36:33,720
That's the introductory phase.

384
00:36:33,720 --> 00:36:38,440
This is the growth phase.

385
00:36:38,440 --> 00:36:44,080
This is the maturity phase.

386
00:36:44,080 --> 00:36:49,320
And this right here is the decline phase.

387
00:36:49,320 --> 00:36:53,920
You might actually allow cannibalism.

388
00:36:53,920 --> 00:37:00,000
You got a new product and what you want to do is get that out there before you kill off

389
00:37:00,000 --> 00:37:03,180
an old product that's going to replace it.

390
00:37:03,180 --> 00:37:09,480
You might start bringing that new product in knowing very well that it will start to

391
00:37:09,480 --> 00:37:11,560
impact on the revenues.

392
00:37:11,560 --> 00:37:21,080
Once you get into the growth phase, it's going to cause this decline to steepen.

393
00:37:21,080 --> 00:37:27,920
So you might see a place where cannibalism, even though companies do try to avoid cannibalism,

394
00:37:27,920 --> 00:37:35,560
you might see once in a while a product line do that.

395
00:37:35,560 --> 00:37:38,120
There's a new product in the product line.

396
00:37:38,120 --> 00:37:43,640
Then there's an old product that is in its decline phase in the same product line.

397
00:37:43,640 --> 00:37:51,040
And you might, well, let's start getting this new product into the consumer's eyes now.

398
00:37:51,040 --> 00:37:55,880
While this other product, the old one, is still on the shelves, recognizing that it

399
00:37:55,880 --> 00:38:00,040
will eventually kill off the old product.

400
00:38:00,040 --> 00:38:05,360
And during its early years, the new product will cannibalize some of the revenues from

401
00:38:05,360 --> 00:38:07,400
the old product.

402
00:38:07,400 --> 00:38:08,400
It happens.

403
00:38:08,400 --> 00:38:16,360
It's not actually not that uncommon to phase out a product with an introduction of a new

404
00:38:16,360 --> 00:38:21,400
product to replace it.

405
00:38:21,400 --> 00:38:26,960
But cannibalism in general, you just want to be careful that you're not cannibalizing

406
00:38:26,960 --> 00:38:27,960
an old product.

407
00:38:27,960 --> 00:38:33,600
If you are, then you have to subtract the revenues that you're cannibalizing from something

408
00:38:33,600 --> 00:38:35,880
else.

409
00:38:35,880 --> 00:38:48,600
Now on the other hand, you can have synergies where a product actually benefits a product

410
00:38:48,600 --> 00:38:52,800
that's already out there.

411
00:38:52,800 --> 00:38:55,440
It's an add-on.

412
00:38:55,440 --> 00:39:06,160
Other companies do this, where a product that is only for a specialized group, you will

413
00:39:06,160 --> 00:39:14,280
begin to offer new products which add on to the old product and therefore make it easier

414
00:39:14,280 --> 00:39:17,800
for more people to use it.

415
00:39:17,800 --> 00:39:19,980
And that would create a synergy.

416
00:39:19,980 --> 00:39:25,320
Not only would you sell the new product, you would also get more people to jump in on the

417
00:39:25,320 --> 00:39:31,280
old product as well.

418
00:39:31,280 --> 00:39:37,000
I guess you could even argue that Adobe has done that to some extent with its line of

419
00:39:37,000 --> 00:39:38,000
products.

420
00:39:38,000 --> 00:39:40,840
The more it offers add-ons, the more people embrace it.

421
00:39:40,840 --> 00:39:46,240
In a way, Microsoft bringing in these new add-ins for Microsoft, and they just seem

422
00:39:46,240 --> 00:39:52,720
to be coming out all over the place, these new add-ins just make it so that more people

423
00:39:52,720 --> 00:39:56,560
would be willing to use Microsoft Office products.

424
00:39:56,560 --> 00:39:59,120
It's just the way it is.

425
00:39:59,120 --> 00:40:06,200
And also with Excel, you've seen the introduction of Python, which gives more people the interest

426
00:40:06,200 --> 00:40:12,400
in Excel because they've generally been using Python, now they can use the two together.

427
00:40:12,400 --> 00:40:17,080
So you would embrace Excel because you've got your Python right in there with it.

428
00:40:17,080 --> 00:40:20,200
That's a new thing that's out there right now.

429
00:40:20,200 --> 00:40:22,900
So sometimes there can be a synergy.

430
00:40:22,900 --> 00:40:31,240
You don't assume it unless you have good knowledge that your consumers are going to embrace this

431
00:40:31,240 --> 00:40:37,340
product and give that synergy, add that synergy to it.

432
00:40:37,340 --> 00:40:43,260
Those are the warnings about always sandboxing.

433
00:40:43,260 --> 00:40:49,000
You can have cannibalism or you can have synergies happen in them.

434
00:40:49,000 --> 00:40:56,920
One way or the other though.

435
00:40:56,920 --> 00:41:05,300
What to watch out for.

436
00:41:05,300 --> 00:41:11,840
The big one is sunk costs.

437
00:41:11,840 --> 00:41:17,360
You've done a feasibility study on a new project.

438
00:41:17,360 --> 00:41:21,200
Okay, well that's good.

439
00:41:21,200 --> 00:41:26,400
You don't add that to, you don't put that as part of your upfront investment.

440
00:41:26,400 --> 00:41:29,400
You've already spent money.

441
00:41:29,400 --> 00:41:30,400
It's over.

442
00:41:30,400 --> 00:41:31,520
It's gone.

443
00:41:31,520 --> 00:41:36,600
It's not to be used in the analysis of the project itself.

444
00:41:36,600 --> 00:41:41,760
Whatever has already been spent is not part of the analysis.

445
00:41:41,760 --> 00:41:45,440
The next, I can't emphasize that enough.

446
00:41:45,440 --> 00:41:49,760
It just drives me crazy, it drove me crazy as a consultant seeing these companies that

447
00:41:49,760 --> 00:41:56,200
it's thrown into research for a project, for a product or a project.

448
00:41:56,200 --> 00:42:01,200
And then they think, well we have to keep going here because we've already spent all

449
00:42:01,200 --> 00:42:02,200
this money.

450
00:42:02,200 --> 00:42:11,200
Instead of just dumping and running, you hold on to what you've already done and your analysis

451
00:42:11,200 --> 00:42:13,620
is all wrong if you do that.

452
00:42:13,620 --> 00:42:16,440
You've already bought it, so it's done.

453
00:42:16,440 --> 00:42:17,600
It's gone.

454
00:42:17,600 --> 00:42:25,240
So after you buy a new car, you don't include what you paid for that car in any future analysis

455
00:42:25,240 --> 00:42:28,120
of the use of that car or that vehicle.

456
00:42:28,120 --> 00:42:29,120
It's already gone.

457
00:42:29,120 --> 00:42:31,960
You made the decision.

458
00:42:31,960 --> 00:42:36,560
Another one that is just a disaster.

459
00:42:36,560 --> 00:42:47,920
Opportunity cost.

460
00:42:47,920 --> 00:42:54,120
Repurposing something to use in a new project means that it becomes an upfront cost of that

461
00:42:54,120 --> 00:42:56,160
new project.

462
00:42:56,160 --> 00:43:02,480
I've brought up examples of this before and also what happens when you ignore those opportunity

463
00:43:02,480 --> 00:43:03,480
costs.

464
00:43:03,480 --> 00:43:10,920
We're going to build this new stadium, the city is, this new arena and well we already

465
00:43:10,920 --> 00:43:13,520
have the land so we don't have to worry about that cost.

466
00:43:13,520 --> 00:43:15,480
Oh yes you do.

467
00:43:15,480 --> 00:43:21,560
If you don't, then you are going to overvalue the net present value of the project because

468
00:43:21,560 --> 00:43:25,760
that land could have been sold for some price.

469
00:43:25,760 --> 00:43:30,320
So the fact that you're going to repurpose that land for this project means that it becomes

470
00:43:30,320 --> 00:43:32,120
a cost of the project.

471
00:43:32,120 --> 00:43:36,760
We don't have to worry about the director of this project because we've already got

472
00:43:36,760 --> 00:43:39,680
someone who knows how to do this.

473
00:43:39,680 --> 00:43:45,240
No, that person's salary becomes part of the cost of the new project.

474
00:43:45,240 --> 00:43:52,160
Well we've got all this machinery, it's just sitting around and now we can use it for something.

475
00:43:52,160 --> 00:43:54,040
So that's not a cost to us.

476
00:43:54,040 --> 00:43:56,200
We're saving money by using what we already have.

477
00:43:56,200 --> 00:43:58,680
No, you are not saving money at all.

478
00:43:58,680 --> 00:44:01,280
You could have sold that machinery.

479
00:44:01,280 --> 00:44:02,720
That's just the reality of it.

480
00:44:02,720 --> 00:44:04,480
You could have gotten rid of it.

481
00:44:04,480 --> 00:44:12,280
And so anything that you use that you already have, it's still an upfront cost of the project

482
00:44:12,280 --> 00:44:20,400
because you're giving up the next best foregone alternative.

483
00:44:20,400 --> 00:44:22,080
Opportunity cost.

484
00:44:22,080 --> 00:44:23,080
Try that.

485
00:44:23,080 --> 00:44:26,260
Okay, those are the big ones to watch out for.

486
00:44:26,260 --> 00:44:33,920
There are a few other subtle ones along the way that are in the arena of indirect cost,

487
00:44:33,920 --> 00:44:39,520
but I should actually put that here.

488
00:44:39,520 --> 00:44:53,680
Overall, indirect costs, hidden costs of the new project.

489
00:44:53,680 --> 00:44:59,040
We ignore what we think are not really part of it.

490
00:44:59,040 --> 00:45:05,120
Well we've had 18 meetings dealing with getting this new project off the ground.

491
00:45:05,120 --> 00:45:09,000
You are spending on those projects, that project.

492
00:45:09,000 --> 00:45:15,280
You don't see it as that, but the opportunity cost of the time burned up worrying about

493
00:45:15,280 --> 00:45:17,960
this project was part of the cost.

494
00:45:17,960 --> 00:45:20,560
Did you have C-suite people doing this?

495
00:45:20,560 --> 00:45:25,440
Well guess how their salaries, the part of their salaries that you could increment on

496
00:45:25,440 --> 00:45:32,920
this project, that's a cost you should look at when you start doing the analysis.

497
00:45:32,920 --> 00:45:36,560
Okay, enough of all that.

498
00:45:36,560 --> 00:45:53,920
Let me go do this now.

499
00:45:53,920 --> 00:46:08,880
The free cash flow is going to be the revenues minus the costs, and I'm going to put here

500
00:46:08,880 --> 00:46:27,480
operating costs, minus the depreciation and amortization, times one minus your tax rate.

501
00:46:27,480 --> 00:46:36,720
Now right now we have 21% is what you would use, because that's what the Tax Act of 2017

502
00:46:36,720 --> 00:46:39,640
set for all corporations.

503
00:46:39,640 --> 00:46:52,160
It used to go up until it reached 39%, but now it doesn't.

504
00:46:52,160 --> 00:47:04,120
This piece right here is called NOPAT, the Net Operating Profit After Taxes, NOPAT.

505
00:47:04,120 --> 00:47:24,720
Once you have got NOPAT, you add back the depreciation and amortization, because it

506
00:47:24,720 --> 00:47:28,840
didn't really spend that money.

507
00:47:28,840 --> 00:47:39,960
And then you subtract out your capital expenditures, which you actually spent in physical dollars

508
00:47:39,960 --> 00:47:52,160
to get the project started, and then you calculate the change in net operating working capital.

509
00:47:52,160 --> 00:48:07,040
Net operating working capital is the change is the net operating working capital now minus

510
00:48:07,040 --> 00:48:19,040
the net operating working capital one period back, where NOWC is current assets minus current

511
00:48:19,040 --> 00:48:20,880
liabilities.

512
00:48:20,880 --> 00:48:25,680
Really current operating assets minus current operating liabilities, but don't worry about

513
00:48:25,680 --> 00:48:27,560
that in my class.

514
00:48:27,560 --> 00:48:31,560
I'll make you suffer with that if you take another class.

515
00:48:31,560 --> 00:48:36,000
What's the difference between an operating current asset and a non-operating current asset

516
00:48:36,000 --> 00:48:37,400
and all that?

517
00:48:37,400 --> 00:48:44,320
Just take it as current assets minus current liabilities this period minus the current assets

518
00:48:44,320 --> 00:48:51,200
minus the current liabilities in the next period.

519
00:48:51,200 --> 00:48:53,400
You start a project.

520
00:48:53,400 --> 00:49:02,840
Right now you have inventory at the end of the year of $10 million.

521
00:49:02,840 --> 00:49:09,960
Well once this project is starting, that first year of the project, your inventory is going

522
00:49:09,960 --> 00:49:14,160
to balloon to $12 million.

523
00:49:14,160 --> 00:49:23,740
So your change is positive $2 million, which is a hit to your free cash flow.

524
00:49:23,740 --> 00:49:32,000
As you build up the inventory for the new product, you'll have a hit to your free cash

525
00:49:32,000 --> 00:49:35,640
flow.

526
00:49:35,640 --> 00:49:44,040
You would also in that, well it depends on the product, but in corporate buying, you're

527
00:49:44,040 --> 00:49:50,480
also probably going to have an increase in your receivables.

528
00:49:50,480 --> 00:49:54,760
You're offering terms to get people going with your new product, so you're going to

529
00:49:54,760 --> 00:50:04,600
have your receivables go up from before you had this product.

530
00:50:04,600 --> 00:50:09,640
And also interestingly enough on the liability side though, those are both hits to free cash

531
00:50:09,640 --> 00:50:10,640
flow.

532
00:50:10,640 --> 00:50:12,760
See it's minus a change.

533
00:50:12,760 --> 00:50:16,960
You're using cash to build up your inventory.

534
00:50:16,960 --> 00:50:24,080
You are putting off cash from revenues by allowing receivables to balloon.

535
00:50:24,080 --> 00:50:29,400
Now on the other side, current liabilities, those might actually go up too.

536
00:50:29,400 --> 00:50:34,840
I mean you'll probably owe some suppliers, you'll owe suppliers of your new products,

537
00:50:34,840 --> 00:50:37,800
parts, some money, so your payables will go up too.

538
00:50:37,800 --> 00:50:49,900
So that would be a positive benefit to your net operating working capital, free cash flow.

539
00:50:49,900 --> 00:50:52,440
So it can go both ways.

540
00:50:52,440 --> 00:50:58,640
Net operating working capital, the change can be positive if inventory and receivables

541
00:50:58,640 --> 00:51:07,160
go up a lot, but it could also be negative if your payables go up.

542
00:51:07,160 --> 00:51:12,320
You're not spending money, but you're earning revenue off it.

543
00:51:12,320 --> 00:51:18,000
Kind of hard to explain that way, it's better to just do it in practice than here.

544
00:51:18,000 --> 00:51:21,400
But anyway, these are the pieces of it.

545
00:51:21,400 --> 00:51:28,160
Now salvage value.

546
00:51:28,160 --> 00:51:33,960
I'm putting together the pieces of this today and then putting it into a more of a comprehensive

547
00:51:33,960 --> 00:51:46,240
thing on Wednesday.

548
00:51:46,240 --> 00:52:09,960
Full salvage value is, how do I want to put this, I don't care for the book's way of saying,

549
00:52:09,960 --> 00:52:22,720
it's what you sell the old equipment for at the end of the project.

550
00:52:22,720 --> 00:52:25,800
I don't want to use the word revenue here.

551
00:52:25,800 --> 00:52:50,280
Well, okay, sale price of equipment minus the book value of the equipment.

552
00:52:50,280 --> 00:52:55,240
Let me explain.

553
00:52:55,240 --> 00:53:21,200
At the end of a project, you sell the equipment for $80,000.

554
00:53:21,200 --> 00:53:27,240
Now you'd been depreciating it from its original, whatever you paid for it at the beginning,

555
00:53:27,240 --> 00:53:33,280
you'd been depreciating it along the way.

556
00:53:33,280 --> 00:53:58,080
The book value at the time of sale is only $20,000.

557
00:53:58,080 --> 00:54:08,680
You depreciated out all of it, but it's $20,000.

558
00:54:08,680 --> 00:54:29,160
So the taxable salvage is the $80,000 you sold it for minus the $20,000 that's book

559
00:54:29,160 --> 00:54:30,480
value.

560
00:54:30,480 --> 00:54:44,620
So you face a tax of $60,000, that's a taxable amount of it.

561
00:54:44,620 --> 00:55:08,000
The tax would be T, the tax rate, times the taxable salvage value.

562
00:55:08,000 --> 00:55:19,360
So you don't get, let's say that that's 21% times $60,000.

563
00:55:19,360 --> 00:55:39,840
So your net salvage value is going to be equal to $80,000 minus 21% times

564
00:55:39,840 --> 00:55:47,960
$80,000.

565
00:55:47,960 --> 00:55:53,700
Otherwise you have to pay tax on the part of that that you hadn't depreciated away.

566
00:55:53,700 --> 00:56:10,920
So in a case like this, if I were to do that, calculator, $80,000 minus.21 times $80,000

567
00:56:10,920 --> 00:56:12,520
equals.

568
00:56:12,520 --> 00:56:16,680
So you get only $63,200.

569
00:56:16,680 --> 00:56:27,240
That would be what you would put in your cash flow analysis, is $63,200.

570
00:56:27,240 --> 00:56:32,240
That's what you get.

571
00:56:32,240 --> 00:56:39,640
It's a lot like work.

572
00:56:39,640 --> 00:56:45,240
Okay got it.

573
00:56:45,240 --> 00:56:49,800
Now here's the thing.

574
00:56:49,800 --> 00:56:59,740
There are a lot of assets, fixed assets, that qualify for what the book calls fast depreciation.

575
00:56:59,740 --> 00:57:07,840
That wasn't a term we used in the old days, but there are these scheduled items that you

576
00:57:07,840 --> 00:57:15,560
can depreciate all of it in one year, or all of it in just a couple of years.

577
00:57:15,560 --> 00:57:24,200
So in cases like that, you know, I mean in a case like that, the book value after a year

578
00:57:24,200 --> 00:57:27,040
or a couple of years is zero.

579
00:57:27,040 --> 00:57:33,980
So you're basically paying tax on the entire price you sell of salvage.

580
00:57:33,980 --> 00:57:41,680
If you depreciate away the whole thing, then whatever you get for it is taxed.

581
00:57:41,680 --> 00:57:48,840
And that's why rapid depreciation is very popular, of course, obviously for tax reasons.

582
00:57:48,840 --> 00:57:56,480
But when you dump that equipment, if you sell it at the end of a project's life, you get

583
00:57:56,480 --> 00:57:59,300
hit with a tax on it.

584
00:57:59,300 --> 00:58:04,620
Because you've wiped out all the book value that would have taken away some of that taxable

585
00:58:04,620 --> 00:58:07,200
salvage value.

586
00:58:07,200 --> 00:58:17,540
It used to be, not even that many years ago, the list of items that qualified for that

587
00:58:17,540 --> 00:58:22,040
fast depreciation wasn't that large.

588
00:58:22,040 --> 00:58:29,720
But anymore, it's like a lot of fixed assets, what are normally fixed assets, are actually

589
00:58:29,720 --> 00:58:36,080
quite surprising.

590
00:58:36,080 --> 00:58:43,360
So yeah, you depreciate them rapidly in a year or a couple of years, but then at the

591
00:58:43,360 --> 00:58:48,040
end when you go to sell off the old equipment, you use the project, you're going to move

592
00:58:48,040 --> 00:58:49,240
on.

593
00:58:49,240 --> 00:58:56,880
You sell that stuff for $100,000 to some company that wants it, and you get hit on the whole

594
00:58:56,880 --> 00:58:59,320
$100,000.

595
00:58:59,320 --> 00:59:06,520
You don't have any book value left to shield the exposure to the tax.

596
00:59:06,520 --> 00:59:09,580
So that can happen.

597
00:59:09,580 --> 00:59:29,840
But anyway, essentially, everything that you're going to do is going to be essentially a project.

598
00:59:29,840 --> 00:59:49,000
You'll have your initial investment, but you're going to have something else too.

599
00:59:49,000 --> 00:59:56,520
Because it's in that initial investment phase that you will start to have your inventory.

600
00:59:56,520 --> 01:00:03,760
Your inventory, you'll have to build that up before you start the operations.

601
01:00:03,760 --> 01:00:09,920
So you're going to have to appreciate that there's going to be a change in net operating

602
01:00:09,920 --> 01:00:15,960
working capital right off the bat.

603
01:00:15,960 --> 01:00:22,700
Well for the equipment to do this product, we paid a million dollars.

604
01:00:22,700 --> 01:00:28,160
And also in that first, before we launched the product, we put in, we build our inventory

605
01:00:28,160 --> 01:00:32,200
up, we spent $100,000 on inventory.

606
01:00:32,200 --> 01:00:36,880
Well that's going to go in your initial, your first year.

607
01:00:36,880 --> 01:00:40,340
You may have other things happen too in that first year.

608
01:00:40,340 --> 01:00:45,840
So this initial investment, when you think about it being just your capital expenditures

609
01:00:45,840 --> 01:00:51,860
starting out the project, no, there could be other things involved in it too.

610
01:00:51,860 --> 01:00:54,320
So you've got to appreciate that.

611
01:00:54,320 --> 01:01:04,040
And then from year to year, one, two, three, and then let's say year seven, you're just

612
01:01:04,040 --> 01:01:10,680
going to be working on this free cash flow.

613
01:01:10,680 --> 01:01:19,940
Year one, free cash flow in year two, free cash flow in year three on down through to

614
01:01:19,940 --> 01:01:27,480
whatever remaining free cash flow you have in the last year, in this case the seventh

615
01:01:27,480 --> 01:01:30,000
year.

616
01:01:30,000 --> 01:01:38,640
Don't forget that there will be two things happening there.

617
01:01:38,640 --> 01:01:47,520
You'll have your free cash flow, but you also don't forget that you will have the net salvage

618
01:01:47,520 --> 01:01:58,400
value and you'll have an extra special.

619
01:01:58,400 --> 01:02:06,440
Now you may have changes in net working capital up here, net operating working capital down

620
01:02:06,440 --> 01:02:11,920
here, because you're going to burn off the last of the inventory, that's going to make

621
01:02:11,920 --> 01:02:17,960
net operating, change in net operating working capital go down.

622
01:02:17,960 --> 01:02:20,000
So that frees up cash.

623
01:02:20,000 --> 01:02:24,480
In that last year, you sell off inventory, but you don't replace it.

624
01:02:24,480 --> 01:02:30,400
So that's going to be a source of free cash flow in the last year of the project.

625
01:02:30,400 --> 01:02:37,960
The net salvage value is going to be a source of free cash flow in the last year.

626
01:02:37,960 --> 01:02:44,000
Whatever final year sales you have of the product will be free cash flow in the last

627
01:02:44,000 --> 01:02:45,280
year.

628
01:02:45,280 --> 01:02:52,920
So that last year will be kind of an exciting thing, because numbers that remain kind of

629
01:02:52,920 --> 01:02:57,860
stable, maybe grew with the growth of the product or whatever, suddenly they begin to

630
01:02:57,860 --> 01:03:00,200
change rather quickly.

631
01:03:00,200 --> 01:03:05,700
Your free cash flow from revenues is dying, but you're going to get money from net salvage

632
01:03:05,700 --> 01:03:11,000
value and you're going to free up cash because you're letting inventory dwindle and you're

633
01:03:11,000 --> 01:03:14,640
not replacing it.

634
01:03:14,640 --> 01:03:17,280
That's all the background.

635
01:03:17,280 --> 01:03:22,520
And once I put some numbers on the board, I won't talk so much about this, it will just

636
01:03:22,520 --> 01:03:25,760
be part of the analysis.

637
01:03:25,760 --> 01:03:31,880
And ultimately all we're doing, once we've gotten those free cash flows laid out, we

638
01:03:31,880 --> 01:03:38,200
find the net present value of the future expected free cash flows and that's how we decide whether

639
01:03:38,200 --> 01:03:42,760
a project is a go or a no go.

640
01:03:42,760 --> 01:03:43,880
That's all I have for you today.

641
01:03:43,880 --> 01:04:04,280
I thank you.