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The Illinois State Collegiate Compendium, Academic Lecture in Business and Economics.

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This is Business Finance, FIL 240 for Autumn semester 2023.

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Today, Project Cash Flows. This is, at least part of it, is an Excel exercise.

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So you'll want to have your Excel spreadsheet open so you can follow along.

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As I had said, these are sort of like, each one of them is its own kind of custom job.

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So it's not really a template, it's just knowing how to set one of these up so that you can just cruise through it

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once you have the numbers in place.

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So that's what I'm trying to accomplish here, at least part of this lecture.

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It's just going to be going through an example and showing you how the setup of an Excel sheet works for one of these problems.

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And once you see it and you've got your own little sort of quasi template in your Excel,

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anything that I would do on a final exam or a quiz would be pretty straightforward for you.

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But before we do anything like that, a look at the rather uninspiring numbers for today.

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You see that the Dow was up a little tiny bit, but the S&P 500 and the NASDAQ were down.

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Well, there's still a little bit of time left in the day, but it's nothing spectacular at all.

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You notice that actually, what happened was the day started off, the opening bell was grim.

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And then from there, it just climbed as much as it could.

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It didn't have a lot of energy, but it got back into positive territory,

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and it sort of bounced around there, at least on the S&P 500 and the Dow.

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The NASDAQ never really did finally make it to positive ground,

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but it may make it up above where it started by the end of the day.

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But crude was down, and then it started to rise.

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It's certainly nowhere near $80 a barrel yet,

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so it's still in that territory where we should see gasoline prices ease off.

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Heaven knows they haven't done that yet,

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but they should begin to back off because the price is staying down there in the 70s right now.

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Gold had a little bit of a surge, as you can see, in the last hour and a half or so,

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but it's not even near that $2,000 benchmark, so it's nothing really to worry too much about.

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Now, the 10-year bond, the yield spiked this morning, as you can see, but then it just dropped back off.

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In other words, investors bought into bond, rather, the investors got rid of bonds,

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which caused the yields go up, and then just as quickly as they dove in,

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they went back out and the yields began to fall.

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So there you go.

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The interest rates, as I said, the interest rate environment is easing off, backing down,

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because the expected inflation is settling out of the economy,

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and there's no expectation that the Fed is going to pop interest rates again.

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It looks like there was a lot of thought that the Fed would do one last interest rate increase,

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but there seems to be some sentiment that that's not going to happen.

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And, of course, as such, since U.S. interest rates aren't going to be going up, they'll be going down.

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That makes the dollar weaker against other currencies,

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so that's why you see the euro and the pound sterling appreciating.

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The yen, it's just kind of flopping around there, not really much of a direction.

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But as you can see over on the other side of the world last night,

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Tokyo started out in a pretty good mood, but it just tailed off and finally finished up pretty much where it started.

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But London seemed to have a big surge there at the end, a lot of enthusiasm right there.

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See that spike on the spark chart?

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If you go over here, we didn't really replicate that spike.

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We started out in the toilet and climbed back out,

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so something happened between when the sun set over in London and when it rose on the East Coast of the United States.

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Investors got really sour.

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Just a quick look at the volume on the S&P 500 to see what's going on.

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Oh, that's just miserable.

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It's not going to make half of our normal days trading.

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Investors just staying on the sidelines.

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It's just no direction.

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We're doing pretty good in the economy, nothing spectacular,

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and there's definitely not any real signs of a bad, something bad happening on the horizon

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as long as we stay out of the sort of billowing war in the Middle East.

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So there's nothing really excellent and nothing really bad,

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so the markets, the investors are just going to stay on the sidelines for the time being,

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and that's why you didn't see a whole lot of activity in any of these markets today.

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This is one of those days that you kind of, kind of hard to say anything about it, good or bad.

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Just a look at a couple of retailers.

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We have a, what was I thinking?

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I saw something, there is some sentiment, oh, I know what I saw.

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There was a survey of consumer households, how much they were expecting to spend this year on Christmas,

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and that was actually encouraging.

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The average household was saying about, it will spend about $1,600 on Christmas this year, up from last year.

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Now, I'm not going to see that, and probably most of you won't see anyone buying you $1,600 worth of stuff this Christmas,

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but I mean, if consumers do come through with what they're projecting,

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that means it's going to be a good Christmas season that boosts the economy going into next year,

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and that's what it's all about, is getting us through any last doubts that we're in a recovery and maybe starting an expansion,

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and that means the good jobs will be out there for you to worry about.

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Just a quick look around the markets, just to look at Walmart, just for the fun of it.

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Walmart is, oh, look at that though.

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Do any of you see what I'm seeing about Walmart?

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Okay, nice low beta, very safe stock, it's valued about where it should be, profitable, of course.

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Now, if you take the numbers here, the projection here is that in a year, Walmart will be, per share, $168.69,

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from where it is now, divided by $167.46, minus one, times 100.

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That's, wait, let's try that again.

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Something I did was very wrong there, $168.89, divided by $167.45, minus one, times 100.

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Good grief.

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It won't even make a percent of capital gain, 0.86% of capital gain on the stock.

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Well, you, of course, do have to add in the dividend, which is a lousy 1.37%.

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So, a one year hold on Walmart would get you a total holding period return of a lousy 2.23%.

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Now, that's a little surprising, but, I mean, Walmart is not going out of business,

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but that's just like a dead stop in the growth of the revenues.

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And I've already looked at some of the other major, I'm trying to think of another major retailer

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that I haven't looked at, just to see what they're looking like.

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I looked at Target, I looked at, what else is a large retailer, for heaven's sakes?

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Broad-based big box retailer?

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No, not Winn-Dixie, I can't think of one right now.

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Let me look over here really quick.

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I'm going to pull up another company here, and I've mentioned this one before.

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I might have even looked at its stock before.

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Yum, Yum Brands, large restaurant holding company.

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Restaurants in general, especially chains, have been showing signs of weakness.

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There was a big thing, Burger King, which uses the franchise model,

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has just had three of its major franchisees go tap city, go into bankruptcy.

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That's not good, as opposed to McDonald's, which is most not nearly as franchise dependent.

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So Yum Brands is a holder of restaurants.

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So we've got Yum, okay, Yum,

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about a market beta, a little bit 1.04, a little above the market,

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somewhat undervalued at P-E ratio of 23.86, profitable, $5.26 per share,

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and it pays a little dividend.

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So having a look at that one, just to keep you fresh on those, calculating that,

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143.43, boy that's going to be wild on the podcast.

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If you're going to grow a beard, don't let it grow too long, okay?

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Otherwise you have your sneeze staying with you for a while.

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Where the hell was I?

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Oh, 143.43 divided by 125.51 minus one equals times 100.

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Well that's not bad, the capital gain, oh wait, something's wrong there.

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Let's try that again.

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143.43 divided by, I can't do a calculator worth a darn today,

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125.51 minus one equals times 100, okay.

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There we go.

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Oh, that's decent, 14.28% return,

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and you add in the dividend, 1.92%.

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That's about what you would expect of a market risk portfolio, about 16.20%.

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Not bad, I mean, if you're into restaurants,

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that would be something that you might consider putting into your portfolio.

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That's the risk of the overall market, and a darn decent return of 16.20%.

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So, if that's your thing, you could try that.

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I did see something I would caution you,

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in general I would caution you about the cryptocurrencies,

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but now I'm seeing some brokers really pushing ETFs that are crypto-based.

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And that's like, yeah, you're diversifying terrible risk with more terrible risk,

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so that might not be the best place to start with your investments in assets,

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even if you want to diversify through ETFs, but there you go.

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Okay, taking all this off the board here.

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Now I'm going to pull up a spreadsheet.

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I won't use it right away, and I'll do some of this on Wednesday.

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I'll make it a little more visually comfortable for me.

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Okay, and speaking of risk, and some of this I've said before,

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this is the consolidation.

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When we talk about risk,

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I'll find the marker that actually works here.

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Okay, I can look at three different kinds of risks that should be considered

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when you're looking at projects.

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This is project analysis, a single project.

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Now I've said these before, and I'm just going to repeat them.

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There is the standalone risk.

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That's a project's risk on its own,

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as if this is a separate company, its own thing.

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And the best way to measure this is with measure,

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is the standard deviation.

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Risk measure would be the standard deviation of the cash flows.

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Or the coefficient of variation.

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As you've seen me do that before, the CV is just, so in other words,

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standard deviation is sigma,

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and the coefficient of variation is nothing but the standard deviation

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divided by the average of the free cash flows.

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It's the easiest one to do, and it's also kind of unfortunately the only one

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that many companies use for doing project analysis.

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Looking at the risk of a project, they'll just use,

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well we're going to project the free cash flows,

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and we'll take the standard deviation.

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And if we're really feeling frisky,

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we'll take the standard deviation divided by the average of the free cash flows.

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It's, again, it's rather popular to do it that way.

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It's quick, it's easy, it's dirty, and Excel can do a standard deviation like a boss.

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It is, however, it's got its problems.

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And among other things, if you're projecting free cash flows in a real project,

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they're going to have kind of like an odd pattern.

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The same pattern I was showing you before, you remember from marketing,

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we have the introductory period, then the growth period, then the maturity period,

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and then the decline period.

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The problem is the standard deviation is going to be distorted by that kind of odd pattern

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that a lot of projects have, especially when they die off quickly.

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Closed down is going to be a very quick thing,

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and that's going to have a distortionary effect on standard deviation.

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Well, where are they at?

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Now there's a couple of other ones that you might want to consider.

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I'm going to try to think if I can do those in Excel.

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Another measure of the risk is corporate risk.

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As I say, we do projects in a sandbox as if there isn't a corporation there.

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But in fact, there really will be a corporation there.

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Other projects, possibly many other projects.

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So realistically, those projects, their risks are going to be impacting on the risk of this project.

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So this one is the project risk in the context of all the other projects of the company.

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Now what this means is that it's going to be like stocks.

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If the correlation of this project's cash flows is high in comparison with the other projects,

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then there's not going to be much gain from this.

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But if the project correlation between this project and other projects of the company is low,

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they're going to cancel out some of each other's risk.

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So in other words, this depends on the correlation of this project, project's risk,

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with the other company projects.

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Practically speaking, companies tend to, and it's a good thing in a lot of ways,

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it goes to this whole idea of the core competence of the company.

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Companies generally are not really into, well, let's take on a project that really has nothing to do with what we do now.

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Go in a new direction.

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So obviously, in a case like that, you're probably going to have a low correlation of the cash flows of this project with the company's other projects.

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But at the same time, a lot of companies are pretty conservative about this.

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They don't like to go into other fields, something we've not done before,

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because they're going to have to have expertise that they don't have and all this.

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And there are many stories of companies that decide they're going to go into something they've never done before,

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and the results were catastrophic.

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I mean, I could pull, just off the top of my head, I could pull dozens.

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I'll give you an example.

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Many, many years ago, JCPenney was a successful retailer, you know, the nice JCPenney stores.

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It was beginning to show some signs of old age, and it just wasn't renovating its stores to keep up with the times.

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But that really hadn't hit in yet.

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JCPenney was flush with cash.

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They had, well, what are we going to do now?

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Let's move forward into the future.

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Well, what they should have done is move forward into the future by upgrading their stores,

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renovating their sales model and all that good stuff.

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But instead, they decided, hey, let's buy an insurance company.

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So they bought a boutique insurance company called Educators and Executives.

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It catered to educators and executives, low-risk clients, and it was a very profitable operation in its niche market.

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Well, Penny stepped in there, we're going to do it, we're going to put our model into this.

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And of course, being that they were a retailer and they were an aggressive retailer, expansion, expansion, more customers,

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they took this new boutique insurance company and said, let's make more money.

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So what did they do?

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They said, well, we got customers who were educators and executives.

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We got about every one of them we could get.

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So let's start marketing it to other types of people.

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Well, other types of people, insure them and you're going to have more claims and you're going to have more problems.

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And so, oh, well, now our payouts are going up with all these new, less safe people.

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So let's go out and raise more money by taking in even more risky people.

220
00:23:50,000 --> 00:23:54,000
And of course, in the end, it just turned into a catastrophe.

221
00:23:54,000 --> 00:24:01,000
And JCPenney came out of the experience after a number of years hurt,

222
00:24:01,000 --> 00:24:11,000
because they had gone out of their core competency with the brainstorm that they could use the model of their core competency

223
00:24:11,000 --> 00:24:21,000
in a project that was completely unrelated and for which that model did not apply.

224
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And they were just kicked in the butt.

225
00:24:23,000 --> 00:24:28,000
And this has happened to many companies over the years where they step out of their core competency.

226
00:24:28,000 --> 00:24:37,000
Yes, project risk is diminished by considering it in a well-diversified portfolio of projects.

227
00:24:37,000 --> 00:24:47,000
But if you don't know what you're doing, that's just a prescription for disaster.

228
00:24:47,000 --> 00:25:01,000
Now, here's another one. Market risk.

229
00:25:01,000 --> 00:25:06,000
This takes another approach entirely.

230
00:25:06,000 --> 00:25:14,000
In this approach, you're not asking about really the company.

231
00:25:14,000 --> 00:25:22,000
You're asking about the investors in the company, specifically the equity investors.

232
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There's an argument that goes on off and on, but it goes something like this.

233
00:25:31,000 --> 00:25:46,000
You, madam, are an investor. You are the one who should be assessing the risk of investments.

234
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You will buy companies where you see a reward to risk as being high.

235
00:25:52,000 --> 00:25:56,000
You will get rid of companies where the reward to risk is low.

236
00:25:56,000 --> 00:26:02,000
But ultimately, you are the ones who should decide risk.

237
00:26:02,000 --> 00:26:09,000
So why should the company be worried about the risks of projects?

238
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We'll take it on, and it's your job to decide whether you buy or sell our stock based upon the projection of the future expected cash flows.

239
00:26:19,000 --> 00:26:23,000
It's not the company's problem in a very broad sense.

240
00:26:23,000 --> 00:26:31,000
And that argument comes around, usually it comes around when companies are about to take on a stupid project.

241
00:26:31,000 --> 00:26:37,000
Yeah, this is risky, but we'll let Wall Street decide whether it's a good idea or not.

242
00:26:37,000 --> 00:26:47,000
Well, Wall Street's going to say, well, no, it was your job to filter before you hand it to us.

243
00:26:47,000 --> 00:26:51,000
I make you a sandwich.

244
00:26:51,000 --> 00:26:55,000
It happens to be a turd sandwich, but it's not my problem.

245
00:26:55,000 --> 00:27:01,000
It's your problem before you eat it to see if it's a turd sandwich.

246
00:27:01,000 --> 00:27:03,000
You understand that?

247
00:27:03,000 --> 00:27:07,000
So you are going to come to my restaurant, right?

248
00:27:07,000 --> 00:27:11,000
Because, I mean, you're saying, oh, hell, no.

249
00:27:11,000 --> 00:27:20,000
You see, that's kind of the theory of the market risk theory is that it's not the company's issue, really.

250
00:27:20,000 --> 00:27:22,000
It's the investors.

251
00:27:22,000 --> 00:27:28,000
They'll decide on their – they'll let us know after the fact, probably.

252
00:27:28,000 --> 00:27:34,000
But that, interestingly enough, that haunts us in corporate because that's –

253
00:27:34,000 --> 00:27:41,000
and that's why we will oftentimes give rumors that we're going to try a new project

254
00:27:41,000 --> 00:27:54,000
and see what happens when Wall Street and all the other rich investors react to what we are saying that we might do or we're considering.

255
00:27:54,000 --> 00:28:02,000
We'll leak information just to see if there is an unfavorable reaction.

256
00:28:02,000 --> 00:28:09,000
Because, remember, the ultimate thing that happens, if it's the investors love it,

257
00:28:09,000 --> 00:28:16,000
well, they're going to buy the stock, the stock price will go up, and our weighted average cost of capital will go down.

258
00:28:16,000 --> 00:28:19,000
Remember how the price is in the denominator of the cost?

259
00:28:19,000 --> 00:28:21,000
Well, that's what this is all about.

260
00:28:21,000 --> 00:28:29,000
And if the investors say, oh, this sucks, we're getting out of here, they'll sell, drive the price down,

261
00:28:29,000 --> 00:28:37,000
and as the price goes down, the cost of equity goes up, and so the weighted average cost of capital goes up.

262
00:28:37,000 --> 00:28:46,000
So ultimately, this is a test to see what happens to our cost of capital

263
00:28:46,000 --> 00:28:52,000
when we float trial balloons about new directions of the company and all of that.

264
00:28:52,000 --> 00:29:01,000
A lot of companies are actually quite afraid of this in the sense that they don't go outside of their core business model.

265
00:29:01,000 --> 00:29:12,000
They stay right in it, from retailers to defense industry companies to even companies that are involved in high technologies.

266
00:29:12,000 --> 00:29:20,000
They let that kind of really wild action be done by startups and by companies,

267
00:29:20,000 --> 00:29:24,000
and they'll wait to see what happens before they step into it,

268
00:29:24,000 --> 00:29:30,000
and they'll wait to see how they can integrate it into their existing core business model.

269
00:29:30,000 --> 00:29:35,000
This is the case with oil companies and these new green energies.

270
00:29:35,000 --> 00:29:42,000
They are not stupid. They want to see how the market shakes out before they throw billions.

271
00:29:42,000 --> 00:29:52,000
They could throw billions into any one of these projects, wind, solar, title, even fusion,

272
00:29:52,000 --> 00:29:56,000
but they're stepping back and they're going to say, we'll let the market figure this out,

273
00:29:56,000 --> 00:30:01,000
and then once we know how to make money off this energy source, well, that's what we do.

274
00:30:01,000 --> 00:30:05,000
We make money off energy, but they'll wait for that to happen.

275
00:30:05,000 --> 00:30:17,000
And so that, of course, slows development, in some cases, most unfortunately, but there you are.

276
00:30:17,000 --> 00:30:30,000
Okay.

277
00:30:30,000 --> 00:30:38,000
Well, let me...one thing that I do want to point out,

278
00:30:38,000 --> 00:30:47,000
that market risk is actually, from what we do in research on what has actually happened in the real world,

279
00:30:47,000 --> 00:30:53,000
we find that market risk and corporate risk are quite related.

280
00:30:53,000 --> 00:31:01,000
That's what I was talking about before, is that these two tend to be very much similar to each other,

281
00:31:01,000 --> 00:31:07,000
because the corporate is going to watch the market, the market is going to watch the corporate,

282
00:31:07,000 --> 00:31:15,000
so they're going to sort of move in kind of tandem, in kind of a coordinated, elegant dance,

283
00:31:15,000 --> 00:31:18,000
I should say, not so elegant dance.

284
00:31:18,000 --> 00:31:28,000
Whither goes the market, the corporate will follow, whither goes the corporate, the market will react to it.

285
00:31:28,000 --> 00:31:33,000
So those two tend to be somewhat, more than somewhat related.

286
00:31:33,000 --> 00:31:37,000
But there you go.

287
00:31:37,000 --> 00:31:46,000
One thing that we can do, once we have set up that model, the free cash flow for each year of the project and all that,

288
00:31:46,000 --> 00:32:03,000
one thing that you will see pretty popular is the sensitivity analysis.

289
00:32:03,000 --> 00:32:11,000
All you do is change...you take your model, you've got your free cash flow under base scenario,

290
00:32:11,000 --> 00:32:21,000
and then what you do is you simply change one number, like the growth rate of sales.

291
00:32:21,000 --> 00:32:32,000
While we are projecting that the growth rate of sales will be 10%, so what happens if it's only 5%, what happens if it's 15%.

292
00:32:32,000 --> 00:32:45,000
How robust, and I'll explain that word again in a minute here, how robust is the NPV and IRR to that change?

293
00:32:45,000 --> 00:32:53,000
When I say robust, robust means insensitive.

294
00:32:53,000 --> 00:32:58,000
You sir are robust to the winter.

295
00:32:58,000 --> 00:33:06,000
You walk off, wow, ha ha ha, you're insensitive to the summer, wow, ha ha ha.

296
00:33:06,000 --> 00:33:19,000
Whereas maybe me, oh my god, it's 40 degrees, I'm freezing my ass off, or it's 100 degrees, someone put some barbecue sauce on me.

297
00:33:19,000 --> 00:33:32,000
We want to know, okay, you changed the revenue from 10% to 5%, the net present value stays positive.

298
00:33:32,000 --> 00:33:34,000
Oh, well that's interesting.

299
00:33:34,000 --> 00:33:44,000
So in other words, we can be a little wrong and we're on our baseline projection and the project is still good.

300
00:33:44,000 --> 00:33:49,000
How much does it take to drive it into negative NPV territory?

301
00:33:49,000 --> 00:34:02,000
Or if you've got a project that is just barely above NPV zero in the base scenario, well what happens if we have a glitch?

302
00:34:02,000 --> 00:34:05,000
Another one that you can change is cost of goods sold.

303
00:34:05,000 --> 00:34:10,000
Usually we have that as a percent of your revenues.

304
00:34:10,000 --> 00:34:14,000
Okay, our base scenario says cost of goods sold is 40% of revenues.

305
00:34:14,000 --> 00:34:20,000
What happens when we get into this project if our wholesalers pop price on us?

306
00:34:20,000 --> 00:34:23,000
What happens if it goes to 45%?

307
00:34:23,000 --> 00:34:25,000
What happens if it goes to 50%?

308
00:34:25,000 --> 00:34:35,000
Seeing how much leeway we have in something we can't control like our wholesale prices, the wholesale costs,

309
00:34:35,000 --> 00:34:45,000
how far does it have to go before a good positive NPV project turns into a bad negative NPV project?

310
00:34:45,000 --> 00:34:55,000
And again, how robust is the free cash flow to the assumption of changes in free cash flow?

311
00:34:55,000 --> 00:35:02,000
Another one that is being played, how robust is it to the tax rate?

312
00:35:02,000 --> 00:35:10,000
Sooner or later we're going to have the tax rate come back up a little bit, at least a little we hope, we think.

313
00:35:10,000 --> 00:35:16,000
So we're at 21% right now. What happens if we go to 25%?

314
00:35:16,000 --> 00:35:19,000
What happens if we go to a 30%?

315
00:35:19,000 --> 00:35:26,000
How much of a change would it take to knock this project off its pedestal?

316
00:35:26,000 --> 00:35:28,000
That kind of thing.

317
00:35:28,000 --> 00:35:31,000
So that's sensitivity analysis.

318
00:35:31,000 --> 00:35:36,000
There is a kind of a flaw.

319
00:35:36,000 --> 00:35:45,000
There's a criticism of sensitivity analysis in the sense that the argument is you're going to change one thing

320
00:35:45,000 --> 00:35:50,000
and see the cascade effect down at the free cash flow NPV line.

321
00:35:50,000 --> 00:36:00,000
Well, sometimes what changes one thing could actually change something that's not directly dependent upon it.

322
00:36:00,000 --> 00:36:05,000
Okay, wholesale prices have popped 10%.

323
00:36:05,000 --> 00:36:09,000
Okay, well, that was just our wholesalers being greedy?

324
00:36:09,000 --> 00:36:13,000
No, that might have been an expectation of increasing inflation,

325
00:36:13,000 --> 00:36:18,000
which means that that's going to affect our sales, general and administrative expenses.

326
00:36:18,000 --> 00:36:25,000
We're going to have to offer higher salaries because inflation is starting to go up.

327
00:36:25,000 --> 00:36:30,000
So sometimes sensitivity analysis can lead you astray.

328
00:36:30,000 --> 00:36:34,000
It's not one thing. It's actually multiple things that can change,

329
00:36:34,000 --> 00:36:38,000
and you're just pretending it's one thing that is changing.

330
00:36:38,000 --> 00:36:40,000
So that's sensitivity analysis.

331
00:36:40,000 --> 00:36:43,000
Now, these kinds of things that I'm saying here,

332
00:36:43,000 --> 00:36:50,000
they're obviously not so much for an exam or a quiz in terms of numbers,

333
00:36:50,000 --> 00:36:58,000
but they can be something that you could talk about in terms of a multiple choice question or fill in the blank.

334
00:36:58,000 --> 00:37:04,000
I could describe a type of risk, and you'd have to tell me,

335
00:37:04,000 --> 00:37:10,000
is this a standalone risk, a corporate risk, or a market risk, those kinds of things.

336
00:37:10,000 --> 00:37:15,000
So putting in practical terms for your survival in this class,

337
00:37:15,000 --> 00:37:21,000
know it at that kind of a level, what I've just talked about here.

338
00:37:21,000 --> 00:37:28,000
Now, I'll look at some numbers, put some numbers down for you to have some fun with,

339
00:37:28,000 --> 00:37:32,000
and just to lay it out.

340
00:37:32,000 --> 00:37:37,000
And what I'll do is today I will do the initial layout,

341
00:37:37,000 --> 00:37:44,000
and then on Wednesday I will kill it off mercifully with how you get it all done.

342
00:37:44,000 --> 00:37:50,000
But in any case, one thing that you do want to do, starting right off the bat,

343
00:37:50,000 --> 00:37:55,000
is you have, when you open Excel, you have a sheet.

344
00:37:55,000 --> 00:37:59,000
Sheet one, okay.

345
00:37:59,000 --> 00:38:04,000
Always, if you're going to do this kind of thing,

346
00:38:04,000 --> 00:38:07,000
okay, we've got a sheet.

347
00:38:07,000 --> 00:38:09,000
Okay, we've got a sheet two.

348
00:38:09,000 --> 00:38:19,000
Create a sheet two, which is where you put the inputs.

349
00:38:19,000 --> 00:38:22,000
And that's why I call that sheet.

350
00:38:22,000 --> 00:38:25,000
Sheet two is the inputs.

351
00:38:25,000 --> 00:38:32,000
That way, for one thing, you've got the numbers in a place where they're not cluttered by,

352
00:38:32,000 --> 00:38:34,000
well, I've got to do a formula here.

353
00:38:34,000 --> 00:38:37,000
No, these are just the numbers themselves.

354
00:38:37,000 --> 00:38:44,000
And then you can call those by reference into the calculation sheet.

355
00:38:44,000 --> 00:38:54,000
Okay, and we'll call that one free cash flow, sheet one, free cash flow.

356
00:38:54,000 --> 00:38:58,000
So to start off with though, we're going to take the numbers,

357
00:38:58,000 --> 00:39:02,000
and we're just going to put them in one after the other.

358
00:39:02,000 --> 00:39:06,000
Now, I'll probably be a little haphazard here with this,

359
00:39:06,000 --> 00:39:10,000
but the basic scenario is obvious.

360
00:39:10,000 --> 00:39:15,000
And also, this is good for sensitivity analysis as well,

361
00:39:15,000 --> 00:39:22,000
because then you can tweak a number and, surprise, you've got it where you want it,

362
00:39:22,000 --> 00:39:25,000
what you want to happen in the core sheet.

363
00:39:25,000 --> 00:39:39,000
So just to do this, you're going to start out with your equipment costs.

364
00:39:39,000 --> 00:39:45,000
Costs.

365
00:39:45,000 --> 00:40:01,000
Now let's say that the, that is $200,000.

366
00:40:01,000 --> 00:40:16,000
No, let me make it a little bit, 280,000.

367
00:40:16,000 --> 00:40:28,000
Depreciation schedule, just to make this a little bit easier, is 100%.

368
00:40:28,000 --> 00:40:32,000
In other words, it's what the book calls bonus depreciation.

369
00:40:32,000 --> 00:40:36,000
You may hear me call it rule 179 depreciation.

370
00:40:36,000 --> 00:40:45,000
In other words, you can expense the entire amount in the first year.

371
00:40:45,000 --> 00:40:51,000
Matter of fact, let me do something here.

372
00:40:51,000 --> 00:40:58,000
You code, you don't have to do this.

373
00:40:58,000 --> 00:41:25,000
Cells.entire column.

374
00:41:25,000 --> 00:41:40,000
Oh, I'm losing entire column cells.

375
00:41:40,000 --> 00:41:41,000
I'm trying to remember.

376
00:41:41,000 --> 00:41:42,000
Is it auto-fit?

377
00:41:42,000 --> 00:41:43,000
Auto-fit.

378
00:41:43,000 --> 00:41:45,000
I could not, I was blanking.

379
00:41:45,000 --> 00:41:48,000
God, I did it last time, I think I showed you this.

380
00:41:48,000 --> 00:41:49,000
Yeah, you did.

381
00:41:49,000 --> 00:41:50,000
Okay, there.

382
00:41:50,000 --> 00:41:54,000
Happy now?

383
00:41:54,000 --> 00:41:56,000
Okay, auto-fit.

384
00:41:56,000 --> 00:41:58,000
And then I can close that.

385
00:41:58,000 --> 00:42:09,000
And all that does, it's just a stupid little pet trick so that the, all the columns will slice appropriately on their own.

386
00:42:09,000 --> 00:42:13,000
Okay.

387
00:42:13,000 --> 00:42:16,000
And I'm going to put here tax rate.

388
00:42:16,000 --> 00:42:19,000
I should have probably put that as something else.

389
00:42:19,000 --> 00:42:33,000
And just for, just to make the numbers pretty obvious, 25%.

390
00:42:33,000 --> 00:42:55,000
And now we'll do changes in net working capital.

391
00:42:55,000 --> 00:42:57,000
Didn't work, okay.

392
00:42:57,000 --> 00:43:00,000
Changes in net working, operating working capital.

393
00:43:00,000 --> 00:43:09,000
Inventories.

394
00:43:09,000 --> 00:43:25,000
They will go up initially by $25,000.

395
00:43:25,000 --> 00:43:42,000
Then you'll have accounts payable will rise by $5,000.

396
00:43:42,000 --> 00:43:59,000
Net change will be equal to the increase in current assets minus the increase in current liabilities.

397
00:43:59,000 --> 00:44:07,000
So on net we will suffer a cash outflow of $20,000.

398
00:44:07,000 --> 00:44:11,000
We're spending $25,000 on extra inventories.

399
00:44:11,000 --> 00:44:17,000
However, we are not going to pay $5,000 of those right away.

400
00:44:17,000 --> 00:44:25,000
So the net cash bleed is only $20,000.

401
00:44:25,000 --> 00:44:28,000
Okay.

402
00:44:28,000 --> 00:44:33,000
Operations.

403
00:44:33,000 --> 00:45:00,000
And in this one we'll have new sales are going to be 100,000 units.

404
00:45:00,000 --> 00:45:04,000
I'll show you a trick for this if you want.

405
00:45:04,000 --> 00:45:08,000
Units.

406
00:45:08,000 --> 00:45:14,000
Price per unit.

407
00:45:14,000 --> 00:45:24,000
$2.

408
00:45:24,000 --> 00:45:33,000
Variable cost.

409
00:45:33,000 --> 00:45:38,000
We'll take a variable cost of 60% to start with.

410
00:45:38,000 --> 00:45:48,000
And then we can do scenario analysis or something like that.

411
00:45:48,000 --> 00:45:58,000
Life of project.

412
00:45:58,000 --> 00:46:03,000
Years.

413
00:46:03,000 --> 00:46:16,000
Four.

414
00:46:16,000 --> 00:46:36,000
Equipment eligible for 100% depreciation.

415
00:46:36,000 --> 00:46:48,000
100% of the equipment. We'll just make it simple that way.

416
00:46:48,000 --> 00:47:10,000
Salvage value.

417
00:47:10,000 --> 00:47:18,000
After tax salvage value.

418
00:47:18,000 --> 00:47:27,000
Salvage value minus book value.

419
00:47:27,000 --> 00:47:48,000
Times 1 minus the tax rate would be equal to 25,000.

420
00:47:48,000 --> 00:48:08,000
Minus 100% times 25,000.

421
00:48:08,000 --> 00:48:13,000
Book value.

422
00:48:13,000 --> 00:48:19,000
I'm thinking here. I really don't need to make it that complicated.

423
00:48:19,000 --> 00:48:33,000
It's just the after tax salvage value is going to be salvage value equals $25,000

424
00:48:33,000 --> 00:48:49,000
minus zero simply because you depreciated all the way times 1 minus the tax rate.

425
00:48:49,000 --> 00:48:56,000
Where did I put the tax rate? Right there.

426
00:48:56,000 --> 00:49:00,000
Don't boo me.

427
00:49:00,000 --> 00:49:11,000
Yeah, because you basically depreciated all the way so if you sell for 25,000 you're exposed to $25,000 in taxes.

428
00:49:11,000 --> 00:49:29,000
So $25,000 minus 25% of $25,000 means you're going to get to keep after you've paid the tax on what you sold at the end of the project $18,750.

429
00:49:29,000 --> 00:49:54,000
And that looks like that's about, oh, after tax capital expenditure.

430
00:49:54,000 --> 00:50:14,000
Well, you're going to get to get some tax relief from that so that's going to be equal to the capital expenditure times 1 minus the tax rate.

431
00:50:14,000 --> 00:50:24,000
You're not booing me. Really? Oh, I see.

432
00:50:24,000 --> 00:50:28,000
I didn't put it in parentheses.

433
00:50:28,000 --> 00:50:50,000
So that's what you spent after taxes for the $280,000 worth of equipment.

434
00:50:50,000 --> 00:50:58,000
Okay.

435
00:50:58,000 --> 00:51:09,000
This is the setup and then we would go over here and we can do it either as a row or as a column, however you would wish to do it.

436
00:51:09,000 --> 00:51:21,000
I'll put it like this, year free cash flow.

437
00:51:21,000 --> 00:51:23,000
Oh, it's working now.

438
00:51:23,000 --> 00:51:49,000
And just to make it pretty, I'll reverse the font to white and black and then we'll have year 0, 1, 2, 3, 4.

439
00:51:49,000 --> 00:51:54,000
Life of project. Okay, free cash flow.

440
00:51:54,000 --> 00:52:12,000
The capital expenditures at the beginning will first of all be equal to the after tax cost of the investment

441
00:52:12,000 --> 00:52:29,000
plus the net change at the beginning in working capital, that amount.

442
00:52:29,000 --> 00:52:45,000
And actually I should make that a negative to keep Excel from getting upset. Negative on that.

443
00:52:45,000 --> 00:52:48,000
Quit bitching at me for heaven's sakes.

444
00:52:48,000 --> 00:52:50,000
Always criticizing me.

445
00:52:50,000 --> 00:52:56,000
Negative 1 times, yeah, there we go.

446
00:52:56,000 --> 00:53:02,000
I'm putting a negative in there just because it's a negative, it's outflow of cash.

447
00:53:02,000 --> 00:53:11,000
Yeah.

448
00:53:11,000 --> 00:53:18,000
I sit here doing this.

449
00:53:18,000 --> 00:53:45,000
Wait a minute, how are you...oh wait.

450
00:53:45,000 --> 00:53:48,000
Yeah, I forget to do that and then I'm typing along.

451
00:53:48,000 --> 00:53:57,000
I get a little fragile with this because I've got to make sure I wrote the formula right.

452
00:53:57,000 --> 00:54:02,000
Okay, so there's the initial.

453
00:54:02,000 --> 00:54:08,000
Now we cruise along here, we get the year to year on it.

454
00:54:08,000 --> 00:54:18,000
Okay, for year one we'll get our equals our revenues,

455
00:54:18,000 --> 00:54:44,000
which will be the 100,000 units times $2 per unit minus 100,000 times $2 per unit.

456
00:54:44,000 --> 00:54:46,000
What the heck?

457
00:54:46,000 --> 00:54:48,000
What happened there?

458
00:54:48,000 --> 00:54:49,000
Let's try it again.

459
00:54:49,000 --> 00:55:10,000
Equals 100,000 units times $2 per unit minus $100,000 per unit times $2 per unit times 60%.

460
00:55:10,000 --> 00:55:30,000
I could have probably done that more elegantly.

461
00:55:30,000 --> 00:55:35,000
What are you blooming about?

462
00:55:35,000 --> 00:55:55,000
Equals formula text times, open parenthesis, that close the parenthesis.

463
00:55:55,000 --> 00:55:59,000
Why did that...let me copy that formula.

464
00:55:59,000 --> 00:56:03,000
There we go, it did that time.

465
00:56:03,000 --> 00:56:08,000
And I'll upload this tonight.

466
00:56:08,000 --> 00:56:19,000
And then for up to year three, wait, I forgot to absolute reference those.

467
00:56:19,000 --> 00:56:24,000
Yeah, I forgot to do absolute references on those.

468
00:56:24,000 --> 00:56:36,000
F4, B12, B11, B12, absolute references, I just hit F4 when I put it on there.

469
00:56:36,000 --> 00:56:38,000
There you go.

470
00:56:38,000 --> 00:56:42,000
And then that should fix that.

471
00:56:42,000 --> 00:56:51,000
There we go.

472
00:56:51,000 --> 00:56:55,000
And then year four.

473
00:56:55,000 --> 00:57:06,000
We will have one last year of the...

474
00:57:06,000 --> 00:57:09,000
Well, actually, I could do a nasty little trick here.

475
00:57:09,000 --> 00:57:17,000
I could copy that formula down and then I can edit it to include the last things.

476
00:57:17,000 --> 00:57:35,000
The first thing is that we're going to have to add back the inventory because we close the project out

477
00:57:35,000 --> 00:57:41,000
minus we have to pay off the accounts payable.

478
00:57:41,000 --> 00:58:03,000
And then we have to take into account the after-tax salvage value plus that.

479
00:58:03,000 --> 00:58:05,000
Try that again.

480
00:58:05,000 --> 00:58:18,000
Got it. Okay, we have to add back the inventory because we can get rid of it now.

481
00:58:18,000 --> 00:58:24,000
We have to pay off the payables right there.

482
00:58:24,000 --> 00:58:32,000
And then we get to add the after-tax salvage value.

483
00:58:32,000 --> 00:58:44,000
There we go.

484
00:58:44,000 --> 00:58:50,000
And now we can do one last thing.

485
00:58:50,000 --> 00:59:02,000
Let's say on the input sheet we put the weighted average cost of capital as let's say 10.00%.

486
00:59:02,000 --> 00:59:10,000
So now what we can do is we can find the net present value of the project.

487
00:59:10,000 --> 00:59:25,000
NPV, it will be equal to the initial plus the net present value of those...

488
00:59:25,000 --> 00:59:27,000
Whoops.

489
00:59:27,000 --> 00:59:30,000
Wait, I don't want to do that.

490
00:59:30,000 --> 00:59:33,000
Let's try that again.

491
00:59:33,000 --> 00:59:53,000
The initial cash outflow plus the NPV, open the parenthesis, using our weighted average cost of capital, comma, these.

492
00:59:53,000 --> 01:00:01,000
Okay, what's wrong here?

493
01:00:01,000 --> 01:00:04,000
Does anyone see what...

494
01:00:04,000 --> 01:00:06,000
Let's try it one more time.

495
01:00:06,000 --> 01:00:30,000
We're going to have the initial cash outflow equals the initial cash outflow plus the NPV, open parenthesis, the rate, which is 10%, comma, the values.

496
01:00:30,000 --> 01:00:35,000
And then we'll close the parenthesis.

497
01:00:35,000 --> 01:00:50,000
There it is.

498
01:00:50,000 --> 01:01:16,000
And the internal rate of return is going to be equals internal rate of return of the values.

499
01:01:16,000 --> 01:01:19,000
There we go.

500
01:01:19,000 --> 01:01:25,000
I can even make that a couple of decimal places.

501
01:01:25,000 --> 01:01:32,000
Now, I think the book shows you an MIRR for this, for one like this.

502
01:01:32,000 --> 01:01:33,000
There's really no need to.

503
01:01:33,000 --> 01:01:41,000
The only reason you would use a modified internal rate of return is if there were more than one switch in the cash flows, but there's not here.

504
01:01:41,000 --> 01:01:49,000
So that's that.

505
01:01:49,000 --> 01:02:08,000
So that one I will upload, and then I will finish this on Wednesday with another example, just so that you've got it down and you're never going to have a problem with it again.

506
01:02:08,000 --> 01:02:11,000
That's all I have for you today.

507
01:02:11,000 --> 01:02:40,000
I thank you.