Alan Kring Productions in association with Emergent Light Studio presents
the Illinois State Collegiate Compendium, Academic Lecture in Business and Economics.
This is Business Finance, FIL 240 for autumn semester 2023.
Today, Project Analysis.
And just as a few preliminary words, we have a surprise quiz on Wednesday.
I'm going to take you through, just to make absolutely sure,
that you know how to use the templates to be able to accomplish it like a boss.
And from there we'll go on to the project analysis.
For today, that'll spill of course into Wednesday.
I'll do more of the setup today and then just the mathy thing on Wednesday.
But first, a look at the numbers.
And just as a point of departure, take note that the advertisements at Yahoo Finance are generally finance oriented.
And here we have a place where you can actually do your trades in stocks.
It says stocks, options and futures.
And the name of this brokerage house is Tasty Trade.
Now, I'll just leave it at that and let you decide if that's a really good place for you to do your stock trading.
Perhaps you get a meal with every 100 shares you buy.
Something like that.
But anyway, here we go.
The S&P, this was a kind of a rocking session because first the market was up a little bit
and then it dropped just around the end of the midday.
And then it managed to rally and there was more of a rally there at the end.
About an hour and a half ago, these numbers were barely in the positive.
Just a couple hundredths of a percent.
But it did manage to find its wind in its sails.
The Dow ended up about one tenth of a percent up, whoop-de-doo.
And the S&P 500 not quite two tenths of a percent.
And the Nasdaq up three tenths of a percent.
So I would qualify this was a bull day by saying it was about the weakest bull you could get.
Now, and notice here, interestingly enough, something happened at the end that got the markets a little bit awakened.
An hour and a half before the end of trading today, the S&P 500 was not even half,
the volume was not even half of what has been on a typical day.
But there was a surge there at the end and it finished with about 2.2 billion shares
against the average for the year over the past year of 3.7.
So it's not spectacular at all.
There's still a lot of skittishness among investors right now.
They're keeping a lot of money in cash.
Oil is well below that range of 82 to 88.
And it dropped, it tried to rally today, and it finished down, barely up.
Interestingly enough, the price of gasoline has gone up a little bit at the retail level today.
And that probably is more that there is, that oil is being used to produce distillates
because the price of diesel has been up quite, has been rather high lately.
So they may be allocating more of the production to distillates for now.
But if the prices stay down here, eventually you'll see gasoline prices being pretty darned cheap, comparatively speaking.
The gold bugs have backed off a lot, which kind of is an indication that they certainly don't see
any economic apocalypse on the horizon.
And the euro, well, let me talk here.
The 10-year bond, the yield surged up, whoa, almost about 10 basis points, which means the price fell.
Price fell and investors were getting out of bonds.
Looks like a little of their money went into equities, but most of it's probably just going into cash
as the investors want to survey the landscape.
Yields going up will slow down in an economy.
But this is just a one-day thing, so we can hope that that will wane as the week goes along.
The euro and the pound were appreciating into the midday, and then they just started to go down.
Part of it's because our yields on interest rate yields are going up, stronger dollar, weaker euro,
weaker pound, and, well, that's interesting.
The Japanese yen, no, it's weaker too.
Yeah, I keep forgetting the yen is backwards, depreciating.
Okay, so now over here, this is a couple of times recently I've seen this with the Nikkei.
It popped on the opening bell, and then it just floated there for the rest of the day.
So there was news building before the bell, good news building before the bell, and the Nikkei 225 jumps.
And then there's no more into good news, so it just floats right there where it was at the beginning,
up 2 and 1 3% for the day, which is a good day, but I mean, all the good happened on the very opening bell.
London is doing weird things. It just keeps having these volatile sessions.
It was up, then down, and then it surged, and then went down, up, down.
There's a lot of volatility over there in Great Britain and the London exchanges kind of having a hard time
deciding whether it's a bull or a bear every day recently.
Look at a few stocks, just to have a look around, to refresh your memory of how to do things and how to look at them.
And I haven't looked at bank stocks recently, so let's look at Citigroup, one of the 10 too big to fail.
Well, that's interesting because you've got a beta that is, but that's a high-risk beta, 1.55,
but it's undervalued. That PE ratio indicates an undervalued stock, and they're obviously quite profitable,
$6.30 per share, and a nice dividend, almost 5% dividend yield, so there you are.
Kind of a hard call on that one, but just to remind you of doing that calculation for capital gains and dividend yield and all that,
we would take, if you bought it today, in a year, Yahoo is predicting 49.48 per share,
divided by the current price, which you would buy it at a year before you sold it,
42.04 minus 1 equals, and then I multiply that by 100 to get a percent,
and then I add in the dividend yield, 4.92%.
Oh, that's decent. I mean, that's a high beta. Obviously, you expect a high return on it, 22.62%.
That's a healthy yield if it lives up to this projection.
I mean, it's one of those stocks, if you're a risk taker, Citigroup would be something you would look at.
I don't know how excited I would be about it, though, but there you go.
Now, trying to think, oh, let's have a look at something completely different.
I don't pay too much attention to the monsters of the earth, but let's look at Microsoft, MSFT.
It's a rich person's stock, 356.53 per share, up more than a percent today,
but it's lost a lot of that ground, or at least it's lost some of that ground in the aftermarket trading.
But anyway, as you can see, it's relatively safe stock at beta of.88, somewhat overvalued,
and it's got kind of a crappy dividend,.85%.
Obviously, it's a profitable company.
So let's look at what we would get a one-year holding period return, total return on this one.
We'd have $370.22 in a year, divided by the current price you'd buy it at.
It's 356.53 minus one, and then you times that by 100, and then you add the dividend yield,.85%.
So you get a total holding period return of a lousy 4.69%.
I mean, it's below one, so you don't expect a magnificent return, but that's kind of a lousy return for Microsoft.
Didn't see that coming.
So there you go. Just a quick look around, see what kinds of great investments there are out there,
and not so great investments.
But right now, we're kind of looking at a period where the markets are trying to decide
whether they should keep being bullish or if they want to back down from that.
Who knows?
Let me show you something here. Let me get this off.
This is for quiz-type stuff and final, and I talked about this last time,
but when you look at the weighted average cost of capital,
weighted average cost of capital versus the percent of debt in the capital structure.
And of course, one minus that would be the percent of equity in the capital structure.
Okay, so the WAC equation is the weight of debt times the after-tax cost of debt
plus the weight of equity times the cost of equity.
Nothing spectacular about that.
Okay, so look at two scenarios.
No debt. Suppose a company does not use any long-term debt.
Then that would mean that the weight of debt in the portfolio is zero
times the after-tax cost of debt
plus the weight of equity, which would be 100%, times the cost of equity,
which of course means that your weighted average cost of capital would be nothing but the cost of equity.
So in other words, when the weight of debt, when the percent of debt is zero,
the weighted average cost of capital is just the cost of equity.
Now suppose you had a company that was all debt.
Suppose you had one that was all debt.
And in that case, the weight of debt would be 100% times the after-tax cost of debt
plus the weight of equity, there would be no equity, times the cost of equity,
which would then be equal to just the after-tax cost of debt.
So at 100% debt, you would have just the after-tax cost of debt.
And so that would be the weighted average cost of capital curve.
It is in a straight line because as you use more and more debt,
the cost of debt is cheap, so your weighted average cost of capital goes down.
But there's a point where a company borrows so much that it begins to get a high default premium in its debt cost.
And so eventually it starts to turn around.
The bottoming out point is called the optimal capital structure.
It's the combination of debt and equity that minimizes the weighted average cost of capital.
It would do you a world of favor if you knew those three points, where it anchors to the horizontal axis,
where it ends, and where what we call the bottoming out point.
It would be worth your while to know those three values.
And as I had already whined to you, knowing how to use the Excel template that I provided for you
is going to be worth your while to know.
Your job is to read the narrative of the problem and fill in the numbers where they belong in the sheets.
So for example, if I had something where, let's say that you had preferred stock that was going off at, let's say, a 4.8% dividend, par value, $120 a share.
And the current price of it is, oh, let's say, $91.70.
Now, interestingly enough, your book, The Homework Problems, always gave you the next period dividend.
Instead of the current dividend that you would have to grow one period.
But we'll just do it as I've been doing before.
They just paid a dividend of, let's say, $2.50 per share.
And it's expected to grow at, let's say, 6% per year.
And the current price of the stock is, let's say, $29.65.
Now, the bond narrative, I'll give you a price on the 100 for the bond.
Let's say that the price of the bond right now is floating at $105.50.
And this one, let's make it due in 2029.
It pays a coupon of 5.75%.
Par value of the bonds outstanding of the company is $15 million.
Let's say the number of preferred shares is $240,000.
And the number of common shares, let's say it has 30 million common shares.
What you will want to do is just get the numbers out of the narrative,
these boxes as I've put it here, and put them where they belong in the template.
The preferred dividend is 4.8%.
The price of the par value of the stock is $120.
The price of the preferred stock is $91.70.
The number of preferred shares, which you find over here, this is kind of a hodgepodge,
24,240,000.
And the common dividend they just paid is $2.50.
The growth rate of the common stock is 6%.
And the current price is $29.65.
Really should have made that two decimal places.
Now the bond.
The bond matures in six years, so we put in six for the term.
The coupon is 5.75%.
The price on the hundred is $105.50.
And that's all you need to do, you've got your yield.
Now, the par value of the bonds is $15,000,000.
The price of the bonds will calculate itself.
Par value times the price on the hundred.
Number of preferred shares is $240,000.
Number of common shares, $30,000,000.
And you don't need to worry about new common, new issue.
And there's your weighted average cost of capital.
All you have to do is put the numbers in the right places,
and the weighted average cost of capital will calculate out.
As a side note, the capital structure of this company right now is 1.7% debt and 98.3% equity.
You see that?
The equity would be the preferred plus the common,
and that comes up to about 2.4 plus, yeah.
So the capital structure, you don't need to worry too much about this, but
that divided by
well, yeah, divided by 100, one, oh well, divided by some.
And the weight of equity, margin center, would be sum of those two, the equities,
would be the sum of the equities divided by, oops, close the parenthesis,
divided by the sum of all of them equals percentages.
Sum of the equities divided by the sum of all of them.
Oh, those are supposed to be percents.
I don't get that at all.
Why is that doing that?
Let's try it again.
Equals the sum of those two divided by the sum of all three of them.
There we go.
So it's about 98% equity and 2% debt.
That's called the capital structure.
The capital structure is a combination of debt and equity that makes up the total assets.
And again, you don't have to worry about doing any of these calculations.
This calcu- not even this one actually, should have shaded that in.
These will calculate themselves.
All you have to do is get all of the numbers into their boxes and then it does it itself.
So I am going to give you 20 minutes for this quiz just to make sure that you have enough time to sort out the numbers
and put them in the right places.
That's the main thing.
Yeah?
You're going to look up over that second equation.
That thing that I did up here?
Up at the top, yeah.
Right there, that?
The second one, one of them.
All I did in this one was, okay, I said, okay, the debt to the total assets would be that number divided by that.
Matter of fact, I can even make it easier.
I can say, okay, why won't that delete?
I'll just say, what in the world?
Oh, I unplugged my-
Why is this sucking?
There, sorry about that.
Let's try that again.
Nope.
Oh.
Did I break something?
What did I just do?
I don't-
My God, I've broken the computer in here.
Hang on.
There, see if it's-
Try that again.
Sorry about that.
Let's try that.
Okay, one more time.
I take- actually, I'll do it easier this time.
Equals that divided by the total-
Try that again.
Equals that-
No, I'm sorry.
Equals that divided by the total.
And then this one is equal to the sum of the two equity parts, the preferred stock plus the dividend stock-
preferred stock plus the common stock divided by the total.
That's it.
Well, that was awkward.
I almost broke their computer.
I kicked it out of its USB port, the keyboard.
Anyway, so like I said, if you just put the numbers in, you'll get the answer that you want out.
And think about it this way.
If you get a whack, the whack should be in a range between maybe-
it shouldn't be much- anything lower than about 6 to 8 percent.
It shouldn't be anything higher than 18 to 20 percent.
It should be in a- so if you get something in that range, at least you know that you've got a chance at being right.
Okay.
Now, just feel free to try some numbers of your own.
Just play with the worksheet.
Obviously, don't save what you've done.
But just work with it.
Just make sure that you know how to put the numbers in the right places.
And you shouldn't have a problem with the problem- well, I guess it's a problem.
But you shouldn't have much of a problem with the problems on the quiz that do this.
It'll look like you're a hero because the narrative describes all these different parts of the company-
the stock, the prices, and the bonds, and their coupons, and all that kind of- the time to maturity.
So it should work out that you get a right answer for a problem that looks absolutely beastly.
Okay, enough of that.
This is project analysis.
What we are looking for are projections of free cash flow.
But we are going to do it on the level of individual projects.
Now, there are two kinds of individual projects.
There are expansion projects, and this is some stuff that I've talked about before,
which is the way I do things.
I talk about it, and then I formally introduce it.
And here's the formal introduction.
There are expansion projects, and then there are replacement projects.
An expansion project, a good example would be we're going to make a new product.
We've got a product line, we're going to put another product in it.
Or we're going to go to a whole new product line, something like that.
Or we're going to build a new factory, or a new office building, or something along that line.
You are expanding the company in one way or another.
A replacement project is where you are going to take something that you already have
and replace it with something else.
Now, with an expansion project, or with a replacement project,
one important feature of your analysis is going to be what I call the sandbox,
what we call sandbox.
That project exists on its own, separate from anything else.
And all we are looking at is incremental, additional cash flows.
We don't combine them with the company's overall revenues and costs.
We look at the project as it stands on its own.
Now, the only times when you might spill out of the sandbox is if you have a product
that's going to cannibalize another product.
Companies try their best not to have that happen,
unless, I'm going to give you a sort of a broad example of times when you might actually have,
deliberately, some cannibalization.
From your marketing, and you may have seen this somewhere besides marketing,
but when you look at products, over time, you're going to have an introductory phase,
where you don't get hardly any sales.
But then you're going to have a growth phase, and then the maturity phase, and the decline phase.
This is the introductory phase.
You're bringing the product to the shelves, and you're trying to get people to buy it.
Notice it. First, you've got to get people to notice it.
This will be when the people begin to start buying it more.
More buyers, growing market share, whatever you want to call it.
And then you've got this maturity phase.
Sometimes I use an old term, which I don't know is even around now, the cash cow.
It's just there. You're not growing it. You're not taking market share. It just exists.
It's just there. You've got a loyal following for it.
And of course, this is when the barbarians are coming to the gates
with their new and improved knockoffs of your product.
And eventually, you start sliding into this decline phase.
It's not worth pushing marketing campaigns on it.
You're just letting it kind of fizzle out.
There's an interesting thing about cannibalization, though.
Sometimes what you'll do is you'll bring a new product to market
during the decline phase of a product that is like it.
Simply because you can then bring a little more slowly your customers
from the old one to the new one.
And of course, what that will do is that will steepen this decline phase.
But yeah, there's where cannibalization can actually happen.
And it's not a bad thing.
You're just weaning people off the older product and bringing them to the newer product.
So cannibalization isn't a totally negative term.
Now, the other thing that you can sometimes do is have a synergy
where a new product is actually working to increase revenues of an older product,
increase customer embrace.
Now, you see this sometimes in software where a company will have a product.
It's good, but it's for a limited audience.
But over time, what you'll do is add to that product add-ins, filters,
whatever you want to call them, that will make more people embrace your product
because it has now does things that it didn't used to do.
Just slap on a few things onto it.
To some extent, Adobe is in that kind of a category.
Even Microsoft, they have add-ins that merely enhance the value of the core product
and make it even more embraceable.
Like, for example, Microsoft for Excel, they will soon be coming out,
if they haven't already. I don't know if it's already there.
They have integrated Python into Excel.
So your Python users, your programmers who are, well, I do, Al goes,
well, now you can just use Excel, which you should use anyway,
but now you can have Python right in your Excel.
And of course, AI is this AI, quote, unquote, which is an AI.
It's a fast machine learning so far, we hope.
But enhancing, well, by this add-in.
Here's an add-in. We're going to spend money to build it,
and then what you'll do is you will buy the core product because you have this add-in.
The social media platform, formerly known as Twitter, is in the process of that too.
First, they're going to charge almost everyone to use Twitter, okay?
But then they're going to throw in with it their work they're doing on a proprietary AI.
They call it XAI, I think.
So that that will add value to the core product Twitter, which you will have to pay for.
Right now, if you want any possibility of notice, you have to pay a fee of, what is it, $8.99 a month,
and soon anyone who uses Twitter, even if you don't pay the premium fee, you'll have to pay a dollar to be on Twitter.
So in order to enhance the purchase of Twitter, they'll throw in a new goodie,
which I don't know what it's supposed to do, but you know, it's AI,
so some people may pay the dollar just so they have access to the AI on Twitter.
Anyway, pitfalls in the analysis.
The biggest one of all is some costs.
What you've already paid for has nothing to do with the analysis you're doing right now.
Well, we put a lot of money into the research on this.
Now we're ready to look at whether we should do it or not.
We got all the data. Well, that'll be part of the initial investment.
We'll add that $750,000 we did for the research.
No, you won't. You already paid it. It's gone. It's with Jesus now.
You don't need to put it in there. You should not put it in there.
You're never going to get that $750,000 back.
You've already done it, so don't worry about it.
You buy a new car. Well, man, I better keep this car up because I spent all this money.
That's not why you should keep the car, putting money into the car.
All that you're putting money into the car is to hold its current value,
not to recover your initial price you paid.
That's the most difficult thing I had as a consultant was convincing these companies, the executives,
you already spent this money. It's gone.
It has nothing whatsoever to do with your decisions about whether to proceed from here with it.
That's very difficult. And there are even some larger corporations that seem to keep thinking,
well, we've already spent this money, so we better keep going.
It has nothing whatsoever to do with the issue.
So, okay, so there's one.
The next one is opportunity cost.
What else could you have done?
The example that I keep going back to, which I probably used right here.
A city decides to throw the money, taxpayer money, into building some kind of an entertainment venue,
an arena or a stadium. And I saw this.
I've seen this several times, and one, I was in the direct line of fire of it because I asked the wrong question.
Where are the costs of the land that you're going to put this arena on?
Well, we already have the land, so that's a cost we can avoid.
No, it's not. You could have sold the land.
The fact that you're going to build an arena on it means that you gave up the best alternative,
which would have been to sell it.
That piece of land would have gone for about $3 million.
So that's $3 million addition that you will add to the initial investment of building the Dagon thing.
That's a common mistake.
And it falls into the category of a somewhat broader idea of indirect costs, the hidden costs,
the costs you don't see that are still there, but you ignore them.
And that can be a killer on a project.
You think you're saving money, but you're not because you are using resources at the same time.
Well, we've already got our director chosen.
We're going to just shift this guy over here.
He doesn't have enough to do in his current job.
Well, what's his salary? It's $90,000 a year.
Well, that's $90,000 per year added to the wages and salaries.
Well, no, because we already have him on board.
No, you are moving him. You are using him for this project.
So that's $90,000 each year added to the costs.
It's hard for people outside of our world to understand those kinds of concepts.
The do-it-yourselfer who does something, well, I would have paid $500 for this.
It took me about 100 hours to do it.
Well, how much do you make an hour at your job? About $30 an hour.
30 times 100 is $3,000.
And you think you saved money? No, you blew a lot of money.
You creamed yourself on money.
But people don't think about it that way.
Okay, that's fine.
But keep in mind these are all part of what you will probably have to do at some point.
You'll have to be one of those people who is looking through these.
No matter whether you're in finance or marketing or whatever or production,
you have to think about these things and find out what the full cost is.
If you don't, no one will notice until the project dies from losses,
as happens with these arenas.
City after city gets suckered in because they don't look at full cost,
plus the indirect cost.
And then just like somewhere around this area, you have,
we lost another $2 million this year.
We're really, yeah, and that's $2 million that you owe back to the taxpayers
because you screwed up on the forward look on the project.
A little bit, just for your purposes.
Okay, now.
Got a project year, free cash flow.
Got your zero year, one year, two years, three years, four years.
Let's do five years.
And I'm not going to write so much numbers here,
but I'm just going to write the basic idea here.
Okay, free cash flow.
From earlier in the semester, your revenues minus your operating costs
minus your depreciation and amortization
times one minus your tax rate, which is right now 0.21
thanks to the Tax Act of 2017.
Okay.
That animal right there is what we call NOPAT,
Net Operating Profit After Taxes, NOPAT.
And then, so free cash flow is going to be NOPAT.
Now you add back in the depreciation and amortization
because it never really happened.
All you have it there for is because it's a tax shield.
And then you take away your capital expenditures,
which you actually paid,
and you take away your change in net operating working capital.
So now, net operating working capital is just your current operating assets
minus your current operating liabilities.
And for the purposes of a course like this,
we don't distinguish between what is operating current
and what is not an operating current.
They're pretty much about the same for most cases anyway.
And the change in net operating working capital
is net operating working capital in the current period
minus net operating working capital in the previous period.
Stop for a minute.
I'll let you breathe here while I talk a little bit.
Current assets and current liabilities.
At the beginning of a project, well, let's say it's a product.
Before that product hits the shelves,
you've got to build the inventory for it.
So that's a change.
Say you had, your company has inventory of $10 million.
Well, you're figuring that your first year of sales are going to be about,
would justify about $2 million in additional inventory.
So your current assets go up against your current liabilities.
That is a drain on your cash flow.
Another thing that's going to happen on the current assets side is your receivables.
You want to get people to buy, get the product bought,
you will have your receivables will go up.
So in other words, your revenues are going to overstate what happens
because you'll have some of that will show up just as receivables, not cash.
So that would be a drain.
So in other words, current assets going up against current liabilities
will be a drain on free cash flow.
The change in net operating working capital increasing is a drain on free cash flow.
Similarly though, well you got suppliers sending you stuff.
So you're going to have your payables go up, your accounts payable go up.
That means that your expense you report in accounting overstates
what really happened in cash flow.
So your current liabilities going up would be an addition to free cash flow.
You did that on the first test, I gave you one of those,
and I'll probably try it again on the final.
But anyway, so you have this kind of complex thing going on.
You'll have your initial investment at the beginning.
In other words, capital expenditures is going to be the big 800-pound gorilla.
You won't have any real revenues or operating costs so much.
You won't have any depreciation or amortization yet.
So this is going to be dominated by the capital expenditures
and by the net operating working capital increasing.
Now at the end of the project, suppose that you've got a product
and you're going to run it for let's say five years.
In the last year, your inventories, you're going to kill them off.
So that decline in inventories is going to be a source of free cash flow.
But anyway, you'll have your initial investment,
which will include, will be dominated by capital expenditures
and change in net operating working capital.
Those will be the big ones.
And then you'll be cruising along, free cash flow, one free cash flow,
two as these kick in and you don't do much capital expenditure,
and hopefully that stabilizes.
Although if the product is in its growth phase,
you'll probably add more inventory than you pull out year to year
as you need more inventory to satisfy increasing demand.
But what were the other free cash flow?
Three, free cash flow, four.
And then here at the end, some odd things can happen.
One thing is that revenues will be declining
and your variable costs will be declining.
Depreciation and amortization I'll talk about in a minute.
But there will be these other animals showing up.
The capital expenditures may switch to positive because salvage value.
The ending free cash flow in period five,
which will include salvage value.
It will also have, like I said, the normal components,
although these will be declining,
maybe not depreciating and amortization,
but certainly revenues and operating costs are going to be slowing down
as you kill the project off.
You'll be getting some money, free cash flow increase
as you let the inventory just sell off and you don't replace it.
Now the salvage value.
Net salvage value will be the gross salvage,
what you sell it for,
minus the tax on the salvage value.
That's where it gets a little fun, quote unquote fun,
because the tax will be the gross salvage value
minus the book value of the asset
times the tax rate.
You will be taxed on the sale price minus the book value.
So in other words, suppose that you sell the goods
for let's say $800,000.
Now the book value, you haven't depreciated it all the way,
so the book value is still standing at $200,000.
So net salvage value is going to be $600,000.
The tax on that at 21% makes your net salvage value
after tax only,
I'm not even going to try to do that in my head.
I'm going to have a calculator here
and take 600,000 times.21, 126,000.
So your net salvage value is $474,000.
That's how much you get to keep after you pay taxes
on the gross salvage value minus the book.
Couple of pointers here.
And I'll go through this again so I don't sweat that part.
But a couple of pointers here about this.
Notice that the longer you keep the asset,
the more of the depreciation,
the closer you're getting to a book value of zero
because you have more years that you're depreciating.
So that means that you will be exposed to more tax
the longer you keep it, so your net will be lower.
Another interesting part of this,
just a little not too long history.
Back when I was, even when I was founding my own company,
this last one which is still alive for some reason,
there were in that time some assets
which you could depreciate the whole amount in one year.
I think it was called Schedule 179.
It was a very short list though of types of assets
that you could, okay, just knock it off as an expense.
First year, the whole thing.
And there was a list, it was a schedule.
This is something on the list, this is of assets
that you could wipe out the whole salvage value.
Now interestingly enough, over time,
that list has increased quite a bit
the assets that can be expensed all at once
in the year of purchase.
And so that means that there are a lot of assets
where the book value is zero after only a few years.
And so that essentially increases the tax exposure
of the salvage value sale.
Well, we've got this equipment.
We're closing down the project.
We're in year five, and we're going to close down the project.
Okay, we're going to sell the stuff for $600,000.
Well, if under the old rules,
well, we get to subtract $126,000 of that,
and so we pay tax only on $474,000.
But these days, you might find out that after five years,
well, we expense the whole asset on the first year.
So there's a book value of zero,
so you pay tax on the entire amount that you sell the stuff for
at the end of the project.
So that super accelerated depreciation
has the effect of causing you to pay more tax
on the stuff at the end of the project you sell.
It's just the way it is.
Okay, so, taking all together,
we construct the free cash flow stream,
following all this stuff that we're going to do,
the note path, minus capital expenditures,
minus change in net operating, working capital, year to year,
and then we come up with these numbers here,
and then we just take the net present value.
That's the end of the problem.
We just take the NPV of the project
or the internal rate of return, if you will,
and there's the end of the project, right?
There's the end of our analysis.
In talking about it, it's kind of complicated,
but like as an Excel routine or something like that,
it's not all that bad.
Where your danger comes in, of course,
is projecting the revenues.
Operating costs.
Well, how do we project the operating costs?
We do it the old fashioned way.
We take a percentage.
We consider operating costs to be a variable cost,
so they're a percentage of the revenue.
So once you project the revenues, you say,
well, operating costs will be 40% of revenues.
And so, and we know how to write the depreciation.
We just use a depreciation schedule in Excel,
so that's not hard.
We know our tax rate.
That's not hard.
We know what our capital expenditures are going to be
because we've got the bids,
and we've got the winning bid and all that.
Projecting the operating working capital,
we actually do that by a percent of revenues.
Think about it this way.
Your accounts receivable.
We would hope that your accounts receivable
will be a stable percentage of your revenues.
And inventory.
Well, inventory, that should be a fairly stable percentage
of your sales, too.
That's how you get gross margin.
We calculated the gross margin for a product similar to that
as 20%, as 65%.
Okay, that would mean the cost of goods sold was 35% of revenues.
Aha, so it looks kind of complicated procedurally,
but we usually use the percentages,
and we project the numbers based on those percentages.
And then the only challenge is projecting the revenues.
And that's where the pitfalls come in.
You can be overly optimistic.
Well, we're going to sell this product like hotcakes
right out of the box.
Oh, you didn't, did you?
No, we had about a year or two there
where people didn't know what the hell we were selling.
That's the problem, too.
And also another problem is when to kill it.
How long you want to keep it.
You're going to go into, well, I erased it,
but you're going to go into that maturity phase.
Well, when is the maturity phase going to hit?
Three years? Five years? Ten years?
How long is it going to take our competition to figure out
that we've got a winner, and they're going to come in,
and they're going to bleed market share off us like a boss?
Those are the kinds of challenges.
So really, the hard part in a way is projecting the revenues,
being realistic about how quickly the market is going to embrace the product,
how quickly the competition is going to come in
and take our game away from us, and all that.
The rest of it is kind of like just put the numbers together,
and then when it's all over, you just look back and say,
how could we do better the next time we project the cash,
free cash flows for our project?
Well, that's all I have for you today. I thank you.