Alan Kring Productions in association with Emergent Light Studio presents the Illinois
State Collegiate Compendium, Academic Lecture in Business and Economics.
This is Business Finance, FIL 240 for autumn semester 2023.
Today project analysis for multiple projects.
And begin this, this will be something of a mercifully shorter lecture.
I was planning to give you a really big surprise quiz today and then I got all kinds of notices
of people out for illnesses, mostly COVID.
So I decided I didn't want my tires slashed, give me a quiz under those conditions.
So I finished up the material that I have on chapter 12, which is mostly about mutual
projects where you have to choose one or the other.
In other words, mutually exclusive projects.
And I'll get into some of those details here in a little bit.
But first a look at the markets, a relatively brief look.
It was kind of a decent day.
Oddly, the Dow was up the most at more than half a percent,.58% so far, it's not quite
over yet.
And then the S&P was up, not quite a third of a percent.
And then the NASDAQ was up a little less than a quarter of a percent.
Now that's the opposite of what usually happens.
You usually see the Dow up the least, S&P up more, and then the NASDAQ up the most.
So this was kind of an inverted day.
But it's still a bold day and it's nothing spectacular, but it was a decent day.
One thing that got the markets kind of excited was that the wholesale prices, the producer
price index actually was negative in October.
In other words, a deflation of prices in that market.
And the obvious thinking is that if wholesale prices start to ease back, that would mean
that in a month or two, the retail prices should start to ease back.
That's kind of exciting news.
Not only are we slowing down inflation, we are actually may be turning the corner and
draining the inflation.
And that of course means that the Fed would have very little reason to raise interest
rates anymore, at least for a while.
And so the markets are kind of happy about that.
I would have thought that it would have been even happier, but I get the impression that
there was some already the market participants were expecting favorable inflation news today.
So some of that boost was already there yesterday.
But anyway, good day and good day for the economy and all of that.
And that should, if prices start to ease back, that should stimulate some buying, more buying
into the Christmas season.
And more good news, crude oil sliding down back down to about 76.5 a barrel, and that's
lower energy prices.
That should stimulate some driving.
And of course, if you're going to drive, you might as well drive to a shopping mall.
That's my philosophy anyway, but it looks good.
Favorable all over the place.
And the gold bugs, they had a little bit of a surge and then they started sliding back
again, meaning that the economic apocalypse freaks are in retreat right now.
That's always happy news.
Now the bond yields, that was a little bit different.
The bond yields came up and they've been up today.
They're up about nine basis points.
In other words, 9 one hundredths of a percent.
That's not a huge increase, that's nothing to worry about, but we want to keep an eye
on bond prices.
Bond yields, bond yields are up, which means that bond prices are down.
That would mean that investors in bonds are leaving the bonds and they're putting some
of it into cash, which is what they do these days.
But it looks like some of that money that was in the safe harbor of bonds has now gone
over into equities.
Always good news.
I forgot to check, see how the Standard & Poor's was doing as far as volume goes.
Really sucky volume, probably going to finish up below half of a normal day.
It's really, the investors, a lot of the heavies are just staying off the sidelines.
But anyway, we have the Euro and the Pound and the Yen all depreciating against the dollar.
The dollar is getting stronger and that's always good news.
Stronger dollar, well, kind of good news.
Stronger dollar means weaker foreign currencies.
That means cheaper imports.
And in the Christmas season, when imports are cheaper, that means that a lot of the
stuff that we buy for Christmas coming from other countries will be a little bit cheaper
as well.
So that's kind of good news.
The strong dollar makes imports cheaper and it'll make oil cheaper too, of course, as
an import.
Over on the other side of the Pacific last night, the Nikkei had just a nice slow grind
upward and finished up a nice 2.5%.
So Japan is in a good mood.
And then London later on, London started up and it just bounced around, but it stayed
positive all day.
I think they're almost at the end of their trading day.
Maybe they've already finished.
But it just kind of bounced around, but it stayed in positive territory.
So we've got some of our trading partners in the global economy are in a good mood.
And apparently that good mood is over here with us as well.
So let's keep that going for the time being.
One thing I do want to look at here.
Remember earlier in the semester I showed you one called the VIX.
Now the VIX is a sort of a raw measure of volatility of the markets.
And the VIX, in other words, if the VIX goes up, that indicates more market volatility,
lower risk, and all that good stuff.
And if it's down, that means volatility is settling out, less risk, at least the equities
in the stocks.
And as you can see, it's flat right now.
So that's kind of good news.
Volatility isn't changing much.
Now if you look at it over the past, oh I don't know, let's look at it over the past
month.
Do you see all that volatility measure?
And then as time has gone on toward the present, from later October, well actually from early
October to the present, that volatility, that uncertainty, that risk is draining out of
the markets.
That is actually a good sign.
That means that there should be an emerging confidence.
Real investors, unless you're in exotics like derivatives, investors don't like crazy volatility.
That's risk.
That's not what we really want.
And if you're seeing that kind of uncontained risk, but as you can see, that uncertainty
about what's coming is slowly, well kind of rapidly in there, falling away.
That is a good sign, at least for the health of the economy.
It's like if I saw you running back and forth, jumping up into the air and bouncing down
and then digging a hole, going down into a boing, boing, bing, bong, bong, I'd worry
about you.
But if you're walking along in a straight line and you're maybe a little skip, a little
in the foot, you know, you're a happy guy, maybe a little dip, well that's okay.
It's just when you start going boing, boing, boing, and I think the boy is tweaking, something
like that, that worries me.
That's what we're seeing here.
The markets are calming down.
They're letting up on that uncertainty about what is to come.
And that is healthy for an economy.
And it's another measure that we are coming out of a recovery and at least within the
next few months, we will be in an economic expansion period.
Wonderful news.
So these are basics, and I'm conveying these to you because these are the kinds of things
that are really worth knowing if you decide that you want to be an investor, not a broker,
dealer, or anything, a series seven.
But if you want to do stocks and bonds, then in periods of stability and growth, you move
toward equities.
If it's a period or ETFs that have stocks in them.
And if it's a period of uncertainty or concern, you want to reallocate your portfolio toward
bonds or bond ETFs, as it were, and get out of the way of that kind of volatility.
And so this is an indication that you as an investor who will have some money in the next
months and years, this is sort of a signal that you should lean your investments toward
stocks.
That doesn't mean you completely avoid bonds.
A lot of investors and investment advice kind of goes like this.
In good times, you would maybe allocate 75% of your investments to stocks or to stock
ETFs.
And at the same time, maybe about 20% to bond ETFs and 5% you would keep in cash in your
bank accounts and things like that.
Then if things are starting to turn nasty, not that they have, but you're beginning to
get worried, you begin to shift that portfolio and sell off some of your ETFs and stocks
and use that money to buy into bond ETFs.
Maybe start to move more toward about 50% stocks, 40% bonds, and 10% cash.
And then if it really begins to look pretty sure that it's going to be a bad time, you
get down to the point where you may be 20% stocks and 75% and well, no, probably 20%
stocks, maybe 65% bonds, and then the rest in cash.
In other words, moving towards safety, that's that flight to quality, that's that safe harbor
investment structure.
It's just sort of a rule of thumb and that means though that you do have to keep some
eye on the markets so that you can protect your investments against major swings.
You're not trading every day and you're not jerking your portfolio allocation all around
the place, but you do it based upon your understandings of current markets and the prospects for what's
coming down the road a little ways.
Now right now, if you were to look at some of the investment gurus like Jamie Dimon and
people like that, you would swear that we're about to go to hell in a hand basket.
Listen to your own education, your own judgment, and don't take fancy people for being the
absolute word of God.
They are rich because of factors other than their brilliance as investors.
I can assure you of that.
Anyway, enough of that.
Now as I had said, this is a little bit shorter.
I want to show you something here real quick.
Now I have uploaded a revised version of that project analysis spreadsheet that I was doing
on Monday.
I want to show you how it works just so you can get a feel for it.
I've done sort of a partial fix so that you can use projects that have different lives
in this.
Now if I can find it, files.
Does it really have to be that hard?
Spreadsheets.
And I'm looking for the one project analysis.
There it is.
I'm going to download it and show you this newest one.
Okay, here we go.
Yes, enable editing.
Here we go.
Now let me show you what I've done here.
When you use a spreadsheet, before you even look at the FCF analysis, you go to the inputs
and put in the inputs, enter all of the numbers that you're given because the front end sheet,
the FCF sheet might even have errors in it until you've filled in everything.
And what you'll see, and I put in one here just for the shots and giggles.
Equipment costs $320,000.
Now this one, and I should highlight the ones you don't have to put in.
It's got a formula after it that you don't have to worry about that part.
Okay, so $320,000 of equipment costs, it's eligible 100% for bonus depreciation, so you're
going to kill off the whole gross value, $320,000 in the initial year.
We're going to have a tax rate of 25%, you can change that to 21% or whatever you wish.
And then the after-tax cost of equipment will calculate for you.
Then you go down and you put in how much inventory you have to buy in the initial year.
And then below that you put in how much your accounts payable will increase.
The difference of those is going to be your net operating working capital.
It will increase or decrease, increase it should at the beginning.
So that will calculate on its own.
It's got a formula beside it so you know that it's being calculated for you.
Now the sales, you'll put in the number of units you're selling and the price per unit.
And then the gross revenue will calculate on its own, sales times price.
And then the variable cost, you can put in whatever you want for variable cost.
Is it 60% of sales, 40% whatever.
And then you put in your raw salvage value and your book value, which should be zero
for the problems that I would give you and what the book gives you too.
So you calculate your taxable salvage value, which is your actual salvage value minus the
book.
So the remainder is going to be taxed.
So $25,000 of salvage you're going to get for it.
You don't get to hack off any remaining book value.
So you're exposed to $25,000 minus zero.
So you're exposed to $25,000 in tax, exposed to $25,000 of taxable salvage value.
And then you calculate, this will calculate your after tax.
You don't have to do those.
Now the life of the project, in this example here it's four.
But I've made it so that you can make it another number.
You're going to have to do something on the front end sheet if it's a number bigger than
four.
Now the weighted average cost of capital is 10%.
Now here I've put in the investment rate in case you need to calculate a modified internal
rate of return.
Now we go over here.
Watch what happens if I save the life of the project as five years.
It fills it in automatically.
Now the one thing that you will have to do here, I caution, is that if it's five years,
now I've made it for that here.
But if it's like six years, you just take the first year's formula and you just drag
it and copy it down.
If it's six years, I would have dragged it down one more.
Now a formula will show up there, but nothing, there's no action.
So if I drag this down, watch what would happen if I do, watch what I mean if you do six years.
Suppose I put in a six year project there.
Now notice that the salvage value doesn't calculate.
The salvage value will calculate only at the terminal year of the project.
You see that?
Make sure you see that.
It's doing it for you.
Essentially it's an if statement.
If we are not at the final year, if this year count isn't the same number as the life of
project count, it'll just do the normal formula.
It'll do the fancy formula only if you are at the last year of the project.
Otherwise it'll just calculate a normal year's no path or whatever.
Well that sucked.
And the NPV and the IRR will calculate automatically and the MIRR will calculate automatically
for this.
And as you can see, this sucks.
The project is negative NPV.
Watch what would happen if I change the years back to five.
Isn't that cool?
Your salvage value is occurring one year earlier so that will boost the net present value.
But the one thing that I do caution and I can't fashion a way to do this without a macro.
You will have to copy the first cell, cell B3 down as far as you have numbers to pull
this, to do it.
It's just one of those things.
I can't think of a way, I'm sure there is, but I can't think of a way without writing
macros.
And as I said, if I put macros in this, I can't upload it because the servers flag,
you've got macros, you might be trying to put a virus into our servers.
So it gets touchy about that.
But anyway, there it is.
That should, for a quiz and for the final, that should get you through a project free
cash flow problem.
Just make sure, again, get your numbers all in.
Just get them all in there and don't do anything if you see a formula.
That will calculate.
And then once you've done that, go back over and if you need to fill in more years, just
drag the first one down.
That's my, essentially that's my key frame formula and you copy it down, but copy it
down only as many years as a project is.
That's the only place where you kind of have to think about what you're doing along the
way.
And you can do some practice on this, try different years and you might have to add,
if you've got like a 10 year project, you'd probably have to add a few, insert a few rows
here so that you'd have room for it.
But there you are.
It's all done.
And I did that all for you with my own tired arthritic hands because I love you.
No, I don't.
I just wanted to have you not bitch at me because these problems can get a little intensive
especially.
Now, I can even sophisticated this sheet so that you could have different cash flows in
different years.
I mean, it wouldn't be that hard to do it, but I'll make it like this one on a quiz or
the final exam.
Now, I want to go on and show you, first I'll give you an actual example of it.
Mutually exclusive projects.
You could have one or you can have the other, but you can't have both.
Now here's the weird thing.
They might both be good projects, but you can see this kind of strange thing happen
where let's say you've got project A and you've got project B. And project A has an NPV, net
present value of $2,800 and an internal rate of return of 7.45%.
Project B has a net present value of $2,200, but it has an internal rate of return of 9.05%.
You can't do both of these.
It looks like, at least from the NPV standpoint, that both of them you should accept, but you
might not be able to accept both of the projects.
I'll tell you a place where I, the last time I saw this was a relatively small company.
It wasn't too far from here.
They had a piece of, they had some land and land was not that easy to come by where they
wanted to do their thing.
They needed new office space and it was pretty specialized.
So they were going to have to, they saw the need to put together a relatively modest two-story
office building.
But they also needed that land.
They could use that land to put up some of their, an expansion of their manufacturing
facilities.
They could not do both of them.
Obviously, if you put one on that land, you couldn't put the other.
And they both came out to be like this.
It came out like this.
They were both positive NPV projects at the discount rate that they were using, but they
had the internal rates of return were telling them that the decision from NPV standpoint
would be exactly the opposite of what it would be from the internal rate of return point
of view.
So you have mutually exclusive project.
You got to choose one or the other.
What do you do for something like that?
Now there is an old rule and I'll give you this one first.
Always go with NPV.
However, you have to be sure that you're doing, using a good discount rate.
And you might not want to use the same discount rate for one project as you do for the other.
In the example I gave you, the office building was actually a lower risk project than the
manufacturing facility was.
So the discount rate for the NPV of the office building should be a little lower than it
would be for the industrial facility.
So you've got to take that into consideration.
But all other things being equal, if you've got a choice between one and the other, take
the NPV, the higher NPV.
Generally speaking, NPV is theoretically a stronger measure and in data from past experiences,
we see that if you go with NPV, you're more likely to have success with the decision you
made than if you go with the internal rate of return method.
It's just that's how it works.
However, let's look at something here.
Now the thing is that projects that are mutually exclusive, they're very unlikely to have the
same life of project.
And so it's not really correct to look at NPV and IRR just as raw numbers because the
life of a project has an impact on the outcome of the net present value and internal rate
of return approach.
Take it like this.
You could have a project that is a longer term project, but its cash flows occur out
after more than a few years.
And you compare that to a project which has a very short life, big cash flows right off
the bat.
Comparing their NPVs just on their own might not be a good idea.
Take this one.
Let's say that we have project A and it has a timeline that looks like this.
One, two, three, four, five, six, seven.
And I'm just going to put some numbers in here.
The outflow from project A is let's say $30,000 and then it will put in $6,000 in year one,
$10,000 in year two.
Oh, that's year zero.
Sorry about that.
Draw that line a little better.
And then in year three, let's say $12,000 and then $5,000.
Let's say $8,000 and your after tax, this is three, four, then $4,000 and you've got
an after tax salvage of last year with $4,000 and some extra of $7,000.
Project B takes $25,000 out the door and then $10,000, then $18,000 and then it
takes on a final value.
It just dies off at $6,000.
Well, no, let me make this more realistic.
$12,000 instead of $18,000, put that as $12,000.
Suppose that we use a weighted average cost of capital for it discounted at 8%.
I'm going to bring up a completely new sheet here.
Close.
Do this new, make this bigger for us.
Year, free cash flow A, free cash flow B.
Year zero.
Sequence, what was my longest one?
Seven years.
Hmm.
Let me think here.
Oh, I'm okay.
I'm trying to think of this on the fly.
Sequence.
B2, let's do this again.
Well, one and sequence equals sequence.
Probably would have been easier just to do this, but I should use the, starting with
one.
Forget it, I'm just going to do it stupid way.
Four, five, six did I have?
Six, yeah.
Okay.
So cash flow from A is negative 30,000, then 6,000, oops, and 6,000.
Can't even see my own numbers here.
Ten, twelve, eight, four.
And I had 7,000 at the end.
B, I have negative 25,000, then ten, twelve, six.
Ten, twelve, and six.
We'll take a weighted average cost of capital of 10%.
Now we'll do the NP, oh no, I'm sorry, what was that, 8%, I'm sorry, eight.
And I will do the net present value and the internal rate of return equals NPV for the
net present value of the, oops, I got to do the, I keep forgetting that, equals the cash
out flow plus the NPV of the cash inflows.
And I forgot to put in my weighted average cost of capital.
Positive NPV.
Now we'll do the NPV equals, for B, cell C2 plus NPV of the weighted average cost of capital,
the cash flows from this one.
Ooh, negative NPV.
Internal rate of return for the project A equals, just take all those numbers from year
zero to the end for the first one.
What did I just do there, that was weird.
Let's put in the IRR, 15%, 15.33%.
Good deal.
Okay, for the second project, equals internal rate of return of those four years, year zero
through year three, 6%.
Okay, here's the problem, is that this is not necessarily the best way to do it.
Here's how we, here's the trick that we use.
We can say, okay, we can go with project A, or we could do project B twice, repeated.
So in other words, I could say that in the third year, the last year of project B, let's
try that again.
We could do it over again, starting at year three.
I'm labeling it CFB repeat, so we have two projects of the same life.
How much would that cost us?
Well, it would actually equal the sum of the two, the free cash flows would be the sum
of the two projects.
For the first two, for years zero, one, and two, we would have just the cash flows from
the first project.
So the sum of the project and its repeat would just be the first project.
But it would actually be repeated.
So in that third year, your last year of the first instance of the project B, you'd get
6,000, but you'd spend 25,000.
So the net effect would be losing 19,000.
But then project B would kick in, instead of nothing in years four through six, you
get project B's cash flows over again, the 10,000, 12,000, and 6,000.
So in other words, the repeat of B would equal the net present value, would be that plus
the NPV at the discount rate, the weighted average cost of capital, of years one, years
zero through six of the second project.
Well that sucked.com.
I was kind of hoping it would be a little bit better than that, but look at that.
Well that sure kicked my ass.
I've got to think my numbers through a little clearer so I can get an example that works
and looks better.
But as you can see, not only does project A dominate project B, the first in the simple
analysis, it really dominates it in the second mutual exclusive repeat the project, the shorter
project life again.
But there you go, that's how you would do it.
I'm curious to see what the internal rate of return would look like.
Well there's something else I've got to watch out for here too.
The internal rate of return, I can't really use the internal rate of return on this.
It's the same.
Really?
Oh, I get it.
Okay, do you see why I can't use the internal rate of return on the repeat version of project
B?
It's because it has more than one switch in the sign of the cash flow.
So in other words, I have to use the modified internal rate of return.
So I need to find a reinvestment rate.
Oh, shut up.
The reinvestment rate, let's say the reinvestment rate is 12%.
So in order to do the modified internal rate of return, MIRR, I would have to go over here
and attack this project again, equals MIRR, and you give it all the values, then you give
it the financing rate, your weighted average cost of capital, then comma, give it the reinvestment
rate.
Oops.
Ooh.
That makes sense now.
The modified internal rate of return is actually somewhat better.
It's still not as good as project A, but you have to recognize that if you are going to
do this repeat trick, you have to use a modified internal rate of return because most likely
you'll have a dip, you'll go negative somewhere along the line in the repeat when you have
to start a new version of the project again.
Isn't that interesting?
Ouch.
Yeah.
That's interesting.
But that is how you do a repeat internal rate of return.
Now there's another place where this happens, where you got something you can put on the
same piece of land.
There's another place where you can see mutually exclusive projects.
It doesn't sound like it at first, but this is actually something that happens in projects
that have more technology in them.
A company could have, has two choices.
It can buy electronic equipment, computers, something like that, that cost less, but they
have a short life.
Or it could buy computers, let's say, that cost more, but they have a longer life.
They're more future-proofed.
That's another example of mutually exclusive.
You can go cheap and then have to replace them in three years.
Or you can go expensive and not have to replace them for six or seven years.
And that's this all over again.
And this is something that is actually quite normal these days with companies that use
computers, or anything that is more technology-related.
The big one right now is deciding on whether or not what you're going to do with these
new electric vehicles.
There's a general sentiment that the technology is going to be much better in about four years.
So what you could do is you could stick with diesel fossil fuel cars for the time being,
and then replace those when the technology was better in the electric vehicles.
But you could also just go with the electric vehicles now and know that you're going to
have to throw them out in three or four years.
You have to make a decision one way or the other.
So do we postpone the time when we transition to a greener technology so that it is better,
or do we go with it now and just suffer the consequences?
That's true even with home consumers who buy into new technologies.
We know that some consumers will buy a new technology as soon as it comes out the door,
and it will probably not last very long at all.
Or they could wait a few years until the technology is stabilized, and then buy and have it last
a lot longer.
The classic example of that is what happened with the first generation of flip and fold
phones.
The first generation were expensive, and they just weren't going to last because obviously
the materials technology for the face of them was going to get better.
So you had some consumers grab in, buy on the first round, and then they had to replace
them within two to three years with ones that had better technology and were also cheaper
simply because there were more competitors for them.
Samsung stepped into the market on its own with very expensive flip phones and fold phones.
About three years ago was it?
They were terrible, and they were very expensive.
Then the technology, they're clear into I believe they're fourth generation now or the
fifth generation.
The faces are much less vulnerable to folding and to cracking, and also Motorola's in the
game and a couple of other companies are in the game now, so the prices are lower.
So who are the early buyers?
Interestingly enough, wealthier people who could afford the lower NPVs of their projects.
So there's a good example of the decision making that goes on in companies all the time
these days.
Do we buy now and have a short life, or do we wait or do we spend more money and have
a longer life, or wait and have a longer life?
That's the mutually exclusive part of chapter 12, and that is all I have for you today.
I thank you.