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Alan Kring Productions in association with Emergent Light Studio presents the Illinois

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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 analysis for multiple projects.

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And begin this, this will be something of a mercifully shorter lecture.

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I was planning to give you a really big surprise quiz today and then I got all kinds of notices

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of people out for illnesses, mostly COVID.

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So I decided I didn't want my tires slashed, give me a quiz under those conditions.

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So I finished up the material that I have on chapter 12, which is mostly about mutual

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projects where you have to choose one or the other.

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In other words, mutually exclusive projects.

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And I'll get into some of those details here in a little bit.

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But first a look at the markets, a relatively brief look.

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It was kind of a decent day.

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Oddly, the Dow was up the most at more than half a percent,.58% so far, it's not quite

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over yet.

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And then the S&P was up, not quite a third of a percent.

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And then the NASDAQ was up a little less than a quarter of a percent.

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Now that's the opposite of what usually happens.

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You usually see the Dow up the least, S&P up more, and then the NASDAQ up the most.

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So this was kind of an inverted day.

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But it's still a bold day and it's nothing spectacular, but it was a decent day.

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One thing that got the markets kind of excited was that the wholesale prices, the producer

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price index actually was negative in October.

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In other words, a deflation of prices in that market.

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And the obvious thinking is that if wholesale prices start to ease back, that would mean

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that in a month or two, the retail prices should start to ease back.

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That's kind of exciting news.

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Not only are we slowing down inflation, we are actually may be turning the corner and

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draining the inflation.

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And that of course means that the Fed would have very little reason to raise interest

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rates anymore, at least for a while.

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And so the markets are kind of happy about that.

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I would have thought that it would have been even happier, but I get the impression that

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there was some already the market participants were expecting favorable inflation news today.

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So some of that boost was already there yesterday.

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But anyway, good day and good day for the economy and all of that.

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And that should, if prices start to ease back, that should stimulate some buying, more buying

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into the Christmas season.

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And more good news, crude oil sliding down back down to about 76.5 a barrel, and that's

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lower energy prices.

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That should stimulate some driving.

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And of course, if you're going to drive, you might as well drive to a shopping mall.

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That's my philosophy anyway, but it looks good.

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Favorable all over the place.

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And the gold bugs, they had a little bit of a surge and then they started sliding back

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again, meaning that the economic apocalypse freaks are in retreat right now.

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That's always happy news.

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Now the bond yields, that was a little bit different.

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The bond yields came up and they've been up today.

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They're up about nine basis points.

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In other words, 9 one hundredths of a percent.

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That's not a huge increase, that's nothing to worry about, but we want to keep an eye

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on bond prices.

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Bond yields, bond yields are up, which means that bond prices are down.

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That would mean that investors in bonds are leaving the bonds and they're putting some

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of it into cash, which is what they do these days.

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But it looks like some of that money that was in the safe harbor of bonds has now gone

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over into equities.

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Always good news.

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I forgot to check, see how the Standard & Poor's was doing as far as volume goes.

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Really sucky volume, probably going to finish up below half of a normal day.

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It's really, the investors, a lot of the heavies are just staying off the sidelines.

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But anyway, we have the Euro and the Pound and the Yen all depreciating against the dollar.

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The dollar is getting stronger and that's always good news.

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Stronger dollar, well, kind of good news.

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Stronger dollar means weaker foreign currencies.

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That means cheaper imports.

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And in the Christmas season, when imports are cheaper, that means that a lot of the

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stuff that we buy for Christmas coming from other countries will be a little bit cheaper

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as well.

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So that's kind of good news.

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The strong dollar makes imports cheaper and it'll make oil cheaper too, of course, as

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an import.

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Over on the other side of the Pacific last night, the Nikkei had just a nice slow grind

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upward and finished up a nice 2.5%.

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So Japan is in a good mood.

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And then London later on, London started up and it just bounced around, but it stayed

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positive all day.

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I think they're almost at the end of their trading day.

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Maybe they've already finished.

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But it just kind of bounced around, but it stayed in positive territory.

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So we've got some of our trading partners in the global economy are in a good mood.

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And apparently that good mood is over here with us as well.

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So let's keep that going for the time being.

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One thing I do want to look at here.

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Remember earlier in the semester I showed you one called the VIX.

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Now the VIX is a sort of a raw measure of volatility of the markets.

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And the VIX, in other words, if the VIX goes up, that indicates more market volatility,

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lower risk, and all that good stuff.

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And if it's down, that means volatility is settling out, less risk, at least the equities

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in the stocks.

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And as you can see, it's flat right now.

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So that's kind of good news.

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Volatility isn't changing much.

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Now if you look at it over the past, oh I don't know, let's look at it over the past

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month.

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Do you see all that volatility measure?

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And then as time has gone on toward the present, from later October, well actually from early

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October to the present, that volatility, that uncertainty, that risk is draining out of

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the markets.

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That is actually a good sign.

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That means that there should be an emerging confidence.

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Real investors, unless you're in exotics like derivatives, investors don't like crazy volatility.

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That's risk.

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That's not what we really want.

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And if you're seeing that kind of uncontained risk, but as you can see, that uncertainty

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about what's coming is slowly, well kind of rapidly in there, falling away.

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That is a good sign, at least for the health of the economy.

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It's like if I saw you running back and forth, jumping up into the air and bouncing down

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and then digging a hole, going down into a boing, boing, bing, bong, bong, I'd worry

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about you.

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But if you're walking along in a straight line and you're maybe a little skip, a little

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in the foot, you know, you're a happy guy, maybe a little dip, well that's okay.

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It's just when you start going boing, boing, boing, and I think the boy is tweaking, something

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like that, that worries me.

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That's what we're seeing here.

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The markets are calming down.

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They're letting up on that uncertainty about what is to come.

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And that is healthy for an economy.

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And it's another measure that we are coming out of a recovery and at least within the

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next few months, we will be in an economic expansion period.

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Wonderful news.

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So these are basics, and I'm conveying these to you because these are the kinds of things

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that are really worth knowing if you decide that you want to be an investor, not a broker,

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dealer, or anything, a series seven.

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But if you want to do stocks and bonds, then in periods of stability and growth, you move

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toward equities.

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If it's a period or ETFs that have stocks in them.

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And if it's a period of uncertainty or concern, you want to reallocate your portfolio toward

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bonds or bond ETFs, as it were, and get out of the way of that kind of volatility.

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And so this is an indication that you as an investor who will have some money in the next

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months and years, this is sort of a signal that you should lean your investments toward

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stocks.

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That doesn't mean you completely avoid bonds.

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A lot of investors and investment advice kind of goes like this.

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In good times, you would maybe allocate 75% of your investments to stocks or to stock

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ETFs.

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And at the same time, maybe about 20% to bond ETFs and 5% you would keep in cash in your

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bank accounts and things like that.

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Then if things are starting to turn nasty, not that they have, but you're beginning to

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get worried, you begin to shift that portfolio and sell off some of your ETFs and stocks

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and use that money to buy into bond ETFs.

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Maybe start to move more toward about 50% stocks, 40% bonds, and 10% cash.

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And then if it really begins to look pretty sure that it's going to be a bad time, you

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get down to the point where you may be 20% stocks and 75% and well, no, probably 20%

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stocks, maybe 65% bonds, and then the rest in cash.

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In other words, moving towards safety, that's that flight to quality, that's that safe harbor

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investment structure.

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It's just sort of a rule of thumb and that means though that you do have to keep some

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eye on the markets so that you can protect your investments against major swings.

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You're not trading every day and you're not jerking your portfolio allocation all around

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the place, but you do it based upon your understandings of current markets and the prospects for what's

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coming down the road a little ways.

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Now right now, if you were to look at some of the investment gurus like Jamie Dimon and

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people like that, you would swear that we're about to go to hell in a hand basket.

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Listen to your own education, your own judgment, and don't take fancy people for being the

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absolute word of God.

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They are rich because of factors other than their brilliance as investors.

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I can assure you of that.

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Anyway, enough of that.

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Now as I had said, this is a little bit shorter.

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I want to show you something here real quick.

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Now I have uploaded a revised version of that project analysis spreadsheet that I was doing

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on Monday.

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I want to show you how it works just so you can get a feel for it.

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I've done sort of a partial fix so that you can use projects that have different lives

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in this.

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Now if I can find it, files.

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Does it really have to be that hard?

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Spreadsheets.

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And I'm looking for the one project analysis.

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There it is.

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I'm going to download it and show you this newest one.

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Okay, here we go.

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Yes, enable editing.

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Here we go.

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Now let me show you what I've done here.

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When you use a spreadsheet, before you even look at the FCF analysis, you go to the inputs

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and put in the inputs, enter all of the numbers that you're given because the front end sheet,

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the FCF sheet might even have errors in it until you've filled in everything.

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And what you'll see, and I put in one here just for the shots and giggles.

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Equipment costs $320,000.

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Now this one, and I should highlight the ones you don't have to put in.

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It's got a formula after it that you don't have to worry about that part.

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Okay, so $320,000 of equipment costs, it's eligible 100% for bonus depreciation, so you're

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going to kill off the whole gross value, $320,000 in the initial year.

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We're going to have a tax rate of 25%, you can change that to 21% or whatever you wish.

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And then the after-tax cost of equipment will calculate for you.

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Then you go down and you put in how much inventory you have to buy in the initial year.

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And then below that you put in how much your accounts payable will increase.

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The difference of those is going to be your net operating working capital.

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It will increase or decrease, increase it should at the beginning.

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So that will calculate on its own.

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It's got a formula beside it so you know that it's being calculated for you.

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Now the sales, you'll put in the number of units you're selling and the price per unit.

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And then the gross revenue will calculate on its own, sales times price.

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And then the variable cost, you can put in whatever you want for variable cost.

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Is it 60% of sales, 40% whatever.

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And then you put in your raw salvage value and your book value, which should be zero

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for the problems that I would give you and what the book gives you too.

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So you calculate your taxable salvage value, which is your actual salvage value minus the

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book.

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So the remainder is going to be taxed.

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So $25,000 of salvage you're going to get for it.

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You don't get to hack off any remaining book value.

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So you're exposed to $25,000 minus zero.

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So you're exposed to $25,000 in tax, exposed to $25,000 of taxable salvage value.

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And then you calculate, this will calculate your after tax.

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You don't have to do those.

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Now the life of the project, in this example here it's four.

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But I've made it so that you can make it another number.

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You're going to have to do something on the front end sheet if it's a number bigger than

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four.

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Now the weighted average cost of capital is 10%.

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Now here I've put in the investment rate in case you need to calculate a modified internal

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rate of return.

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Now we go over here.

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Watch what happens if I save the life of the project as five years.

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It fills it in automatically.

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Now the one thing that you will have to do here, I caution, is that if it's five years,

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now I've made it for that here.

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But if it's like six years, you just take the first year's formula and you just drag

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it and copy it down.

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If it's six years, I would have dragged it down one more.

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Now a formula will show up there, but nothing, there's no action.

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So if I drag this down, watch what would happen if I do, watch what I mean if you do six years.

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Suppose I put in a six year project there.

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Now notice that the salvage value doesn't calculate.

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The salvage value will calculate only at the terminal year of the project.

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You see that?

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Make sure you see that.

233
00:20:06,440 --> 00:20:09,120
It's doing it for you.

234
00:20:09,120 --> 00:20:10,720
Essentially it's an if statement.

235
00:20:10,720 --> 00:20:19,480
If we are not at the final year, if this year count isn't the same number as the life of

236
00:20:19,480 --> 00:20:24,520
project count, it'll just do the normal formula.

237
00:20:24,520 --> 00:20:33,760
It'll do the fancy formula only if you are at the last year of the project.

238
00:20:33,760 --> 00:20:40,880
Otherwise it'll just calculate a normal year's no path or whatever.

239
00:20:40,880 --> 00:20:44,880
Well that sucked.

240
00:20:44,880 --> 00:20:53,000
And the NPV and the IRR will calculate automatically and the MIRR will calculate automatically

241
00:20:53,000 --> 00:20:54,000
for this.

242
00:20:54,000 --> 00:20:58,040
And as you can see, this sucks.

243
00:20:58,040 --> 00:21:00,680
The project is negative NPV.

244
00:21:00,680 --> 00:21:08,600
Watch what would happen if I change the years back to five.

245
00:21:08,600 --> 00:21:17,200
Isn't that cool?

246
00:21:17,200 --> 00:21:25,560
Your salvage value is occurring one year earlier so that will boost the net present value.

247
00:21:25,560 --> 00:21:34,520
But the one thing that I do caution and I can't fashion a way to do this without a macro.

248
00:21:34,520 --> 00:21:43,440
You will have to copy the first cell, cell B3 down as far as you have numbers to pull

249
00:21:43,440 --> 00:21:46,320
this, to do it.

250
00:21:46,320 --> 00:21:50,200
It's just one of those things.

251
00:21:50,200 --> 00:21:55,720
I can't think of a way, I'm sure there is, but I can't think of a way without writing

252
00:21:55,720 --> 00:21:56,720
macros.

253
00:21:56,720 --> 00:22:02,720
And as I said, if I put macros in this, I can't upload it because the servers flag,

254
00:22:02,720 --> 00:22:08,700
you've got macros, you might be trying to put a virus into our servers.

255
00:22:08,700 --> 00:22:10,800
So it gets touchy about that.

256
00:22:10,800 --> 00:22:13,720
But anyway, there it is.

257
00:22:13,720 --> 00:22:21,680
That should, for a quiz and for the final, that should get you through a project free

258
00:22:21,680 --> 00:22:25,320
cash flow problem.

259
00:22:25,320 --> 00:22:29,580
Just make sure, again, get your numbers all in.

260
00:22:29,580 --> 00:22:34,560
Just get them all in there and don't do anything if you see a formula.

261
00:22:34,560 --> 00:22:36,160
That will calculate.

262
00:22:36,160 --> 00:22:42,760
And then once you've done that, go back over and if you need to fill in more years, just

263
00:22:42,760 --> 00:22:45,120
drag the first one down.

264
00:22:45,120 --> 00:22:53,480
That's my, essentially that's my key frame formula and you copy it down, but copy it

265
00:22:53,480 --> 00:22:57,400
down only as many years as a project is.

266
00:22:57,400 --> 00:23:01,680
That's the only place where you kind of have to think about what you're doing along the

267
00:23:01,680 --> 00:23:02,680
way.

268
00:23:02,680 --> 00:23:07,720
And you can do some practice on this, try different years and you might have to add,

269
00:23:07,720 --> 00:23:13,000
if you've got like a 10 year project, you'd probably have to add a few, insert a few rows

270
00:23:13,000 --> 00:23:16,240
here so that you'd have room for it.

271
00:23:16,240 --> 00:23:17,240
But there you are.

272
00:23:17,240 --> 00:23:18,240
It's all done.

273
00:23:18,240 --> 00:23:25,960
And I did that all for you with my own tired arthritic hands because I love you.

274
00:23:25,960 --> 00:23:27,120
No, I don't.

275
00:23:27,120 --> 00:23:32,040
I just wanted to have you not bitch at me because these problems can get a little intensive

276
00:23:32,040 --> 00:23:33,040
especially.

277
00:23:33,040 --> 00:23:39,040
Now, I can even sophisticated this sheet so that you could have different cash flows in

278
00:23:39,040 --> 00:23:40,040
different years.

279
00:23:40,040 --> 00:23:46,200
I mean, it wouldn't be that hard to do it, but I'll make it like this one on a quiz or

280
00:23:46,200 --> 00:23:47,400
the final exam.

281
00:23:47,400 --> 00:23:58,800
Now, I want to go on and show you, first I'll give you an actual example of it.

282
00:23:58,800 --> 00:24:01,840
Mutually exclusive projects.

283
00:24:01,840 --> 00:24:06,840
You could have one or you can have the other, but you can't have both.

284
00:24:06,840 --> 00:24:08,080
Now here's the weird thing.

285
00:24:08,080 --> 00:24:16,000
They might both be good projects, but you can see this kind of strange thing happen

286
00:24:16,000 --> 00:24:28,440
where let's say you've got project A and you've got project B. And project A has an NPV, net

287
00:24:28,440 --> 00:24:45,640
present value of $2,800 and an internal rate of return of 7.45%.

288
00:24:45,640 --> 00:25:03,480
Project B has a net present value of $2,200, but it has an internal rate of return of 9.05%.

289
00:25:03,480 --> 00:25:05,560
You can't do both of these.

290
00:25:05,560 --> 00:25:13,280
It looks like, at least from the NPV standpoint, that both of them you should accept, but you

291
00:25:13,280 --> 00:25:16,920
might not be able to accept both of the projects.

292
00:25:16,920 --> 00:25:23,920
I'll tell you a place where I, the last time I saw this was a relatively small company.

293
00:25:23,920 --> 00:25:26,120
It wasn't too far from here.

294
00:25:26,120 --> 00:25:33,840
They had a piece of, they had some land and land was not that easy to come by where they

295
00:25:33,840 --> 00:25:36,440
wanted to do their thing.

296
00:25:36,440 --> 00:25:42,160
They needed new office space and it was pretty specialized.

297
00:25:42,160 --> 00:25:50,460
So they were going to have to, they saw the need to put together a relatively modest two-story

298
00:25:50,460 --> 00:25:52,580
office building.

299
00:25:52,580 --> 00:25:56,720
But they also needed that land.

300
00:25:56,720 --> 00:26:04,080
They could use that land to put up some of their, an expansion of their manufacturing

301
00:26:04,080 --> 00:26:06,280
facilities.

302
00:26:06,280 --> 00:26:08,320
They could not do both of them.

303
00:26:08,320 --> 00:26:12,680
Obviously, if you put one on that land, you couldn't put the other.

304
00:26:12,680 --> 00:26:15,840
And they both came out to be like this.

305
00:26:15,840 --> 00:26:16,840
It came out like this.

306
00:26:16,840 --> 00:26:23,420
They were both positive NPV projects at the discount rate that they were using, but they

307
00:26:23,420 --> 00:26:32,120
had the internal rates of return were telling them that the decision from NPV standpoint

308
00:26:32,120 --> 00:26:35,960
would be exactly the opposite of what it would be from the internal rate of return point

309
00:26:35,960 --> 00:26:37,500
of view.

310
00:26:37,500 --> 00:26:39,600
So you have mutually exclusive project.

311
00:26:39,600 --> 00:26:41,940
You got to choose one or the other.

312
00:26:41,940 --> 00:26:45,760
What do you do for something like that?

313
00:26:45,760 --> 00:26:52,000
Now there is an old rule and I'll give you this one first.

314
00:26:52,000 --> 00:26:53,880
Always go with NPV.

315
00:26:53,880 --> 00:27:00,400
However, you have to be sure that you're doing, using a good discount rate.

316
00:27:00,400 --> 00:27:07,000
And you might not want to use the same discount rate for one project as you do for the other.

317
00:27:07,000 --> 00:27:15,120
In the example I gave you, the office building was actually a lower risk project than the

318
00:27:15,120 --> 00:27:18,360
manufacturing facility was.

319
00:27:18,360 --> 00:27:26,000
So the discount rate for the NPV of the office building should be a little lower than it

320
00:27:26,000 --> 00:27:31,680
would be for the industrial facility.

321
00:27:31,680 --> 00:27:34,840
So you've got to take that into consideration.

322
00:27:34,840 --> 00:27:40,320
But all other things being equal, if you've got a choice between one and the other, take

323
00:27:40,320 --> 00:27:43,720
the NPV, the higher NPV.

324
00:27:43,720 --> 00:27:53,560
Generally speaking, NPV is theoretically a stronger measure and in data from past experiences,

325
00:27:53,560 --> 00:27:59,120
we see that if you go with NPV, you're more likely to have success with the decision you

326
00:27:59,120 --> 00:28:03,120
made than if you go with the internal rate of return method.

327
00:28:03,120 --> 00:28:06,480
It's just that's how it works.

328
00:28:06,480 --> 00:28:20,040
However, let's look at something here.

329
00:28:20,040 --> 00:28:26,360
Now the thing is that projects that are mutually exclusive, they're very unlikely to have the

330
00:28:26,360 --> 00:28:30,440
same life of project.

331
00:28:30,440 --> 00:28:40,280
And so it's not really correct to look at NPV and IRR just as raw numbers because the

332
00:28:40,280 --> 00:28:49,240
life of a project has an impact on the outcome of the net present value and internal rate

333
00:28:49,240 --> 00:28:51,580
of return approach.

334
00:28:51,580 --> 00:28:53,240
Take it like this.

335
00:28:53,240 --> 00:29:00,880
You could have a project that is a longer term project, but its cash flows occur out

336
00:29:00,880 --> 00:29:05,240
after more than a few years.

337
00:29:05,240 --> 00:29:10,880
And you compare that to a project which has a very short life, big cash flows right off

338
00:29:10,880 --> 00:29:14,200
the bat.

339
00:29:14,200 --> 00:29:20,480
Comparing their NPVs just on their own might not be a good idea.

340
00:29:20,480 --> 00:29:22,680
Take this one.

341
00:29:22,680 --> 00:29:28,640
Let's say that we have project A and it has a timeline that looks like this.

342
00:29:28,640 --> 00:29:36,040
One, two, three, four, five, six, seven.

343
00:29:36,040 --> 00:29:44,000
And I'm just going to put some numbers in here.

344
00:29:44,000 --> 00:29:59,080
The outflow from project A is let's say $30,000 and then it will put in $6,000 in year one,

345
00:29:59,080 --> 00:30:05,080
$10,000 in year two.

346
00:30:05,080 --> 00:30:09,600
Oh, that's year zero.

347
00:30:09,600 --> 00:30:10,600
Sorry about that.

348
00:30:10,600 --> 00:30:13,680
Draw that line a little better.

349
00:30:13,680 --> 00:30:28,640
And then in year three, let's say $12,000 and then $5,000.

350
00:30:28,640 --> 00:30:38,320
Let's say $8,000 and your after tax, this is three, four, then $4,000 and you've got

351
00:30:38,320 --> 00:30:57,480
an after tax salvage of last year with $4,000 and some extra of $7,000.

352
00:30:57,480 --> 00:31:27,320
Project B takes $25,000 out the door and then $10,000, then $18,000 and then it

353
00:31:27,320 --> 00:31:30,280
takes on a final value.

354
00:31:30,280 --> 00:31:37,280
It just dies off at $6,000.

355
00:31:37,280 --> 00:31:46,880
Well, no, let me make this more realistic.

356
00:31:46,880 --> 00:31:56,320
$12,000 instead of $18,000, put that as $12,000.

357
00:31:56,320 --> 00:32:09,520
Suppose that we use a weighted average cost of capital for it discounted at 8%.

358
00:32:09,520 --> 00:32:16,080
I'm going to bring up a completely new sheet here.

359
00:32:16,080 --> 00:32:18,800
Close.

360
00:32:18,800 --> 00:32:30,800
Do this new, make this bigger for us.

361
00:32:30,800 --> 00:32:52,040
Year, free cash flow A, free cash flow B.

362
00:32:52,040 --> 00:32:55,040
Year zero.

363
00:32:55,040 --> 00:33:03,320
Sequence, what was my longest one?

364
00:33:03,320 --> 00:33:06,320
Seven years.

365
00:33:06,320 --> 00:33:09,320
Hmm.

366
00:33:09,320 --> 00:33:29,000
Let me think here.

367
00:33:29,000 --> 00:33:37,880
Oh, I'm okay.

368
00:33:37,880 --> 00:33:44,160
I'm trying to think of this on the fly.

369
00:33:44,160 --> 00:33:47,160
Sequence.

370
00:33:47,160 --> 00:34:00,960
B2, let's do this again.

371
00:34:00,960 --> 00:34:08,360
Well, one and sequence equals sequence.

372
00:34:08,360 --> 00:34:17,360
Probably would have been easier just to do this, but I should use the, starting with

373
00:34:17,360 --> 00:34:20,360
one.

374
00:34:20,360 --> 00:34:31,920
Forget it, I'm just going to do it stupid way.

375
00:34:31,920 --> 00:34:34,800
Four, five, six did I have?

376
00:34:34,800 --> 00:34:36,400
Six, yeah.

377
00:34:36,400 --> 00:34:37,400
Okay.

378
00:34:37,400 --> 00:35:01,400
So cash flow from A is negative 30,000, then 6,000, oops, and 6,000.

379
00:35:01,400 --> 00:35:07,600
Can't even see my own numbers here.

380
00:35:07,600 --> 00:35:14,400
Ten, twelve, eight, four.

381
00:35:14,400 --> 00:35:30,040
Ten, twelve, eight, four.

382
00:35:30,040 --> 00:35:37,360
And I had 7,000 at the end.

383
00:35:37,360 --> 00:36:03,120
B, I have negative 25,000, then ten, twelve, six.

384
00:36:03,120 --> 00:36:20,000
Ten, twelve, and six.

385
00:36:20,000 --> 00:36:32,040
We'll take a weighted average cost of capital of 10%.

386
00:36:32,040 --> 00:36:39,440
Now we'll do the NP, oh no, I'm sorry, what was that, 8%, I'm sorry, eight.

387
00:36:39,440 --> 00:36:52,520
And I will do the net present value and the internal rate of return equals NPV for the

388
00:36:52,520 --> 00:37:00,520
net present value of the, oops, I got to do the, I keep forgetting that, equals the cash

389
00:37:00,520 --> 00:37:10,000
out flow plus the NPV of the cash inflows.

390
00:37:10,000 --> 00:37:20,200
And I forgot to put in my weighted average cost of capital.

391
00:37:20,200 --> 00:37:23,860
Positive NPV.

392
00:37:23,860 --> 00:37:46,080
Now we'll do the NPV equals, for B, cell C2 plus NPV of the weighted average cost of capital,

393
00:37:46,080 --> 00:37:49,720
the cash flows from this one.

394
00:37:49,720 --> 00:37:56,480
Ooh, negative NPV.

395
00:37:56,480 --> 00:38:04,480
Internal rate of return for the project A equals, just take all those numbers from year

396
00:38:04,480 --> 00:38:07,840
zero to the end for the first one.

397
00:38:07,840 --> 00:38:13,560
What did I just do there, that was weird.

398
00:38:13,560 --> 00:38:22,240
Let's put in the IRR, 15%, 15.33%.

399
00:38:22,240 --> 00:38:23,240
Good deal.

400
00:38:23,240 --> 00:38:32,400
Okay, for the second project, equals internal rate of return of those four years, year zero

401
00:38:32,400 --> 00:38:40,440
through year three, 6%.

402
00:38:40,440 --> 00:38:54,120
Okay, here's the problem, is that this is not necessarily the best way to do it.

403
00:38:54,120 --> 00:38:58,800
Here's how we, here's the trick that we use.

404
00:38:58,800 --> 00:39:12,160
We can say, okay, we can go with project A, or we could do project B twice, repeated.

405
00:39:12,160 --> 00:39:25,960
So in other words, I could say that in the third year, the last year of project B, let's

406
00:39:25,960 --> 00:39:29,960
try that again.

407
00:39:29,960 --> 00:39:36,200
We could do it over again, starting at year three.

408
00:39:36,200 --> 00:39:54,640
I'm labeling it CFB repeat, so we have two projects of the same life.

409
00:39:54,640 --> 00:39:56,800
How much would that cost us?

410
00:39:56,800 --> 00:40:04,600
Well, it would actually equal the sum of the two, the free cash flows would be the sum

411
00:40:04,600 --> 00:40:07,720
of the two projects.

412
00:40:07,720 --> 00:40:17,960
For the first two, for years zero, one, and two, we would have just the cash flows from

413
00:40:17,960 --> 00:40:19,640
the first project.

414
00:40:19,640 --> 00:40:38,880
So the sum of the project and its repeat would just be the first project.

415
00:40:38,880 --> 00:40:48,240
But it would actually be repeated.

416
00:40:48,240 --> 00:40:57,000
So in that third year, your last year of the first instance of the project B, you'd get

417
00:40:57,000 --> 00:41:01,520
6,000, but you'd spend 25,000.

418
00:41:01,520 --> 00:41:08,680
So the net effect would be losing 19,000.

419
00:41:08,680 --> 00:41:15,160
But then project B would kick in, instead of nothing in years four through six, you

420
00:41:15,160 --> 00:41:22,280
get project B's cash flows over again, the 10,000, 12,000, and 6,000.

421
00:41:22,280 --> 00:41:36,880
So in other words, the repeat of B would equal the net present value, would be that plus

422
00:41:36,880 --> 00:41:49,120
the NPV at the discount rate, the weighted average cost of capital, of years one, years

423
00:41:49,120 --> 00:41:55,720
zero through six of the second project.

424
00:41:55,720 --> 00:41:58,720
Well that sucked.com.

425
00:41:58,720 --> 00:42:04,680
I was kind of hoping it would be a little bit better than that, but look at that.

426
00:42:04,680 --> 00:42:08,400
Well that sure kicked my ass.

427
00:42:08,400 --> 00:42:14,760
I've got to think my numbers through a little clearer so I can get an example that works

428
00:42:14,760 --> 00:42:15,760
and looks better.

429
00:42:15,760 --> 00:42:26,520
But as you can see, not only does project A dominate project B, the first in the simple

430
00:42:26,520 --> 00:42:35,720
analysis, it really dominates it in the second mutual exclusive repeat the project, the shorter

431
00:42:35,720 --> 00:42:41,920
project life again.

432
00:42:41,920 --> 00:42:44,000
But there you go, that's how you would do it.

433
00:42:44,000 --> 00:42:47,800
I'm curious to see what the internal rate of return would look like.

434
00:42:47,800 --> 00:42:53,520
Well there's something else I've got to watch out for here too.

435
00:42:53,520 --> 00:43:06,840
The internal rate of return, I can't really use the internal rate of return on this.

436
00:43:06,840 --> 00:43:10,640
It's the same.

437
00:43:10,640 --> 00:43:12,120
Really?

438
00:43:12,120 --> 00:43:16,360
Oh, I get it.

439
00:43:16,360 --> 00:43:24,080
Okay, do you see why I can't use the internal rate of return on the repeat version of project

440
00:43:24,080 --> 00:43:27,120
B?

441
00:43:27,120 --> 00:43:35,880
It's because it has more than one switch in the sign of the cash flow.

442
00:43:35,880 --> 00:43:40,920
So in other words, I have to use the modified internal rate of return.

443
00:43:40,920 --> 00:43:43,920
So I need to find a reinvestment rate.

444
00:43:43,920 --> 00:43:52,640
Oh, shut up.

445
00:43:52,640 --> 00:44:01,580
The reinvestment rate, let's say the reinvestment rate is 12%.

446
00:44:01,580 --> 00:44:11,240
So in order to do the modified internal rate of return, MIRR, I would have to go over here

447
00:44:11,240 --> 00:44:21,800
and attack this project again, equals MIRR, and you give it all the values, then you give

448
00:44:21,800 --> 00:44:29,080
it the financing rate, your weighted average cost of capital, then comma, give it the reinvestment

449
00:44:29,080 --> 00:44:32,080
rate.

450
00:44:32,080 --> 00:44:35,040
Oops.

451
00:44:35,040 --> 00:44:37,560
Ooh.

452
00:44:37,560 --> 00:44:41,360
That makes sense now.

453
00:44:41,360 --> 00:44:45,660
The modified internal rate of return is actually somewhat better.

454
00:44:45,660 --> 00:44:51,640
It's still not as good as project A, but you have to recognize that if you are going to

455
00:44:51,640 --> 00:44:59,680
do this repeat trick, you have to use a modified internal rate of return because most likely

456
00:44:59,680 --> 00:45:07,200
you'll have a dip, you'll go negative somewhere along the line in the repeat when you have

457
00:45:07,200 --> 00:45:11,000
to start a new version of the project again.

458
00:45:11,000 --> 00:45:20,080
Isn't that interesting?

459
00:45:20,080 --> 00:45:23,320
Ouch.

460
00:45:23,320 --> 00:45:26,360
Yeah.

461
00:45:26,360 --> 00:45:31,120
That's interesting.

462
00:45:31,120 --> 00:45:36,440
But that is how you do a repeat internal rate of return.

463
00:45:36,440 --> 00:45:43,240
Now there's another place where this happens, where you got something you can put on the

464
00:45:43,240 --> 00:45:45,920
same piece of land.

465
00:45:45,920 --> 00:45:51,480
There's another place where you can see mutually exclusive projects.

466
00:45:51,480 --> 00:46:00,160
It doesn't sound like it at first, but this is actually something that happens in projects

467
00:46:00,160 --> 00:46:03,880
that have more technology in them.

468
00:46:03,880 --> 00:46:09,480
A company could have, has two choices.

469
00:46:09,480 --> 00:46:19,280
It can buy electronic equipment, computers, something like that, that cost less, but they

470
00:46:19,280 --> 00:46:22,040
have a short life.

471
00:46:22,040 --> 00:46:30,880
Or it could buy computers, let's say, that cost more, but they have a longer life.

472
00:46:30,880 --> 00:46:34,240
They're more future-proofed.

473
00:46:34,240 --> 00:46:37,200
That's another example of mutually exclusive.

474
00:46:37,200 --> 00:46:42,960
You can go cheap and then have to replace them in three years.

475
00:46:42,960 --> 00:46:49,720
Or you can go expensive and not have to replace them for six or seven years.

476
00:46:49,720 --> 00:46:52,860
And that's this all over again.

477
00:46:52,860 --> 00:47:02,200
And this is something that is actually quite normal these days with companies that use

478
00:47:02,200 --> 00:47:06,620
computers, or anything that is more technology-related.

479
00:47:06,620 --> 00:47:13,560
The big one right now is deciding on whether or not what you're going to do with these

480
00:47:13,560 --> 00:47:15,680
new electric vehicles.

481
00:47:15,680 --> 00:47:24,400
There's a general sentiment that the technology is going to be much better in about four years.

482
00:47:24,400 --> 00:47:33,880
So what you could do is you could stick with diesel fossil fuel cars for the time being,

483
00:47:33,880 --> 00:47:42,500
and then replace those when the technology was better in the electric vehicles.

484
00:47:42,500 --> 00:47:48,840
But you could also just go with the electric vehicles now and know that you're going to

485
00:47:48,840 --> 00:47:53,440
have to throw them out in three or four years.

486
00:47:53,440 --> 00:47:56,400
You have to make a decision one way or the other.

487
00:47:56,400 --> 00:48:06,600
So do we postpone the time when we transition to a greener technology so that it is better,

488
00:48:06,600 --> 00:48:10,960
or do we go with it now and just suffer the consequences?

489
00:48:10,960 --> 00:48:15,720
That's true even with home consumers who buy into new technologies.

490
00:48:15,720 --> 00:48:22,240
We know that some consumers will buy a new technology as soon as it comes out the door,

491
00:48:22,240 --> 00:48:27,160
and it will probably not last very long at all.

492
00:48:27,160 --> 00:48:35,600
Or they could wait a few years until the technology is stabilized, and then buy and have it last

493
00:48:35,600 --> 00:48:37,180
a lot longer.

494
00:48:37,180 --> 00:48:42,760
The classic example of that is what happened with the first generation of flip and fold

495
00:48:42,760 --> 00:48:44,180
phones.

496
00:48:44,180 --> 00:48:52,180
The first generation were expensive, and they just weren't going to last because obviously

497
00:48:52,180 --> 00:48:58,600
the materials technology for the face of them was going to get better.

498
00:48:58,600 --> 00:49:05,860
So you had some consumers grab in, buy on the first round, and then they had to replace

499
00:49:05,860 --> 00:49:13,520
them within two to three years with ones that had better technology and were also cheaper

500
00:49:13,520 --> 00:49:17,160
simply because there were more competitors for them.

501
00:49:17,160 --> 00:49:24,480
Samsung stepped into the market on its own with very expensive flip phones and fold phones.

502
00:49:24,480 --> 00:49:26,560
About three years ago was it?

503
00:49:26,560 --> 00:49:30,400
They were terrible, and they were very expensive.

504
00:49:30,400 --> 00:49:36,960
Then the technology, they're clear into I believe they're fourth generation now or the

505
00:49:36,960 --> 00:49:38,640
fifth generation.

506
00:49:38,640 --> 00:49:47,120
The faces are much less vulnerable to folding and to cracking, and also Motorola's in the

507
00:49:47,120 --> 00:49:53,260
game and a couple of other companies are in the game now, so the prices are lower.

508
00:49:53,260 --> 00:49:56,800
So who are the early buyers?

509
00:49:56,800 --> 00:50:06,880
Interestingly enough, wealthier people who could afford the lower NPVs of their projects.

510
00:50:06,880 --> 00:50:12,140
So there's a good example of the decision making that goes on in companies all the time

511
00:50:12,140 --> 00:50:13,340
these days.

512
00:50:13,340 --> 00:50:20,820
Do we buy now and have a short life, or do we wait or do we spend more money and have

513
00:50:20,820 --> 00:50:26,160
a longer life, or wait and have a longer life?

514
00:50:26,160 --> 00:50:32,040
That's the mutually exclusive part of chapter 12, and that is all I have for you today.

515
00:50:32,040 --> 00:50:56,440
I thank you.