1
00:00:00,000 --> 00:00:10,000
Allen Kring Productions in association with the Emergent Light Studio presents

2
00:00:10,000 --> 00:00:17,000
the Illinois State Collegiate Compendium, Academic Lecturing in Business and Economics.

3
00:00:17,000 --> 00:00:29,000
This is Business Finance, FIL 240 for autumn semester 2023.

4
00:00:29,000 --> 00:00:33,000
Today, extensions of free cash flow analysis.

5
00:00:33,000 --> 00:00:36,000
A few things to start off our happy time together.

6
00:00:36,000 --> 00:00:39,000
I was going to give you a little surprise quiz today,

7
00:00:39,000 --> 00:00:44,000
but I've got so many people who've gotten notices from the dean that they're sick

8
00:00:44,000 --> 00:00:50,000
that I decided I wouldn't give a pop quiz because I don't want my tires slashed on my car.

9
00:00:50,000 --> 00:00:57,000
So this will actually be a little bit shorter lecture because the time allocated for the quiz

10
00:00:57,000 --> 00:01:03,000
is now time that I would have to figure out some improv, and I'm not very good at that right now.

11
00:01:03,000 --> 00:01:11,000
So as we usually do, we'll have a look at the numbers, and the numbers are there.

12
00:01:11,000 --> 00:01:16,000
And it's kind of an interesting day because usually it's the opposite of this,

13
00:01:16,000 --> 00:01:20,000
but today the Dow is up the most, almost a half a percent.

14
00:01:20,000 --> 00:01:28,000
The S&P 500 is up less, at.18,.16 percent,

15
00:01:28,000 --> 00:01:35,000
and then the NASDAQ groveled along and got a lousy.7 percent.

16
00:01:35,000 --> 00:01:38,000
On the bright side, it's bullish.

17
00:01:38,000 --> 00:01:49,000
Clearly there's a broad sentiment of positivity, and part of that is it was sort of suspected.

18
00:01:49,000 --> 00:01:57,000
So a lot of this price was impounded, good news price was impounded over the past couple of days,

19
00:01:57,000 --> 00:02:04,000
but we've now been, the official numbers are in, that wholesale prices went down last month.

20
00:02:04,000 --> 00:02:14,000
It was a negative on the PPI, which is a strong evidence that we are now bringing inflation under control,

21
00:02:14,000 --> 00:02:22,000
and we are hopeful that in the next couple of months we'll see retail prices follow suit.

22
00:02:22,000 --> 00:02:29,000
And that would be good news because we're going into the Christmas season.

23
00:02:29,000 --> 00:02:32,000
If you've got prices going down, you're going to get a lot more sales,

24
00:02:32,000 --> 00:02:40,000
and so that will boost Christmas spending and give us a good juicer going into the next year.

25
00:02:40,000 --> 00:02:48,000
We may be moving then from recovery into a decent little expansion of the economy,

26
00:02:48,000 --> 00:02:53,000
which is good news for everybody and for you with jobs and all that, as I've said before.

27
00:02:53,000 --> 00:02:56,000
So, but it wasn't really spectacular.

28
00:02:56,000 --> 00:03:01,000
The market's reaction wasn't spectacular, first of all because this was expected,

29
00:03:01,000 --> 00:03:06,000
so the price has already reacted nicely to that.

30
00:03:06,000 --> 00:03:12,000
And then also, they're still looking at the volume on the S&P 500.

31
00:03:12,000 --> 00:03:15,000
There was a spike of volume at the end.

32
00:03:15,000 --> 00:03:19,000
You see that volume bar just really raced upward there at the end,

33
00:03:19,000 --> 00:03:26,000
but overall it was still a lousy day compared to the 52-week daily average.

34
00:03:26,000 --> 00:03:35,000
We had about 2.5 billion shares versus 3.7 billion shares a year ago today.

35
00:03:35,000 --> 00:03:40,000
Well, I'm sorry, yeah, the average a year ago.

36
00:03:40,000 --> 00:03:44,000
So we don't have a lot to celebrate.

37
00:03:44,000 --> 00:03:49,000
The heavy money is still staying off the playing field for the time being.

38
00:03:49,000 --> 00:03:56,000
But going back to the numbers here on the top drawer, we've got the crude oil coming down,

39
00:03:56,000 --> 00:04:00,000
and that should push prices of gasoline down.

40
00:04:00,000 --> 00:04:06,000
They're still unusually high compared to what they were when the price of oil was higher than it is now,

41
00:04:06,000 --> 00:04:10,000
but we should see that backing off within the week or so.

42
00:04:10,000 --> 00:04:20,000
And then over here, a little bit notable on the bond market is that bond yields surged upward,

43
00:04:20,000 --> 00:04:23,000
but they eased off there at the end.

44
00:04:23,000 --> 00:04:28,000
Most likely, even though we are pretty sure the Fed isn't going to raise interest rates now,

45
00:04:28,000 --> 00:04:33,000
at least for the foreseeable future because of the positive inflation numbers,

46
00:04:33,000 --> 00:04:42,000
what we probably saw was bond investors selling out of bonds, driving their prices down and the yields up,

47
00:04:42,000 --> 00:04:45,000
and moving at least some of that money into equities,

48
00:04:45,000 --> 00:04:51,000
hence equity prices going up while bond prices are going down and yields are going up.

49
00:04:51,000 --> 00:04:53,000
So there's that.

50
00:04:53,000 --> 00:04:58,000
The gold bugs, they were a little excited. They surged for a while, but then they gave up.

51
00:04:58,000 --> 00:05:06,000
They decided the world isn't going into an economic apocalypse, so gold isn't an issue.

52
00:05:06,000 --> 00:05:12,000
Now, the euro, the pound, and the yen all depreciated against the dollar today.

53
00:05:12,000 --> 00:05:18,000
Stronger dollar, that's good news. Stronger dollar means cheaper imports.

54
00:05:18,000 --> 00:05:23,000
And we're going into the Christmas season, and a lot of what we buy are imports,

55
00:05:23,000 --> 00:05:30,000
and they will have lower prices. All good news for us.

56
00:05:30,000 --> 00:05:41,000
On the other side of the world, last night, the Nikkei just had a long, slow grinding push upward,

57
00:05:41,000 --> 00:05:49,000
finishing off a very smooth bull market for the day, up about 2.5%.

58
00:05:49,000 --> 00:05:57,000
That's good news. And then over in London, it's still volatile, but at least it stayed positive today.

59
00:05:57,000 --> 00:06:04,000
Bullish over in London, and then that sentiment seems to have come across the Atlantic,

60
00:06:04,000 --> 00:06:09,000
and here we are, decent day on Wall Street. So there's that.

61
00:06:09,000 --> 00:06:16,000
Let me show you one thing. I had shown you this several months, or more than a month ago.

62
00:06:16,000 --> 00:06:25,000
I showed you the VIX. The VIX is a raw measure of market volatility.

63
00:06:25,000 --> 00:06:36,000
Higher volatility, higher risk. The market is, well, let's look at the VIX right now.

64
00:06:36,000 --> 00:06:45,000
The VIX was up a tiny bit, but overall, if you look at the VIX over the last, let's say,

65
00:06:45,000 --> 00:06:53,000
oh, six months or so, or a year maybe?

66
00:06:53,000 --> 00:06:57,000
One month. Let's look at the one month. That's a good one.

67
00:06:57,000 --> 00:07:01,000
Notice how the VIX, measuring volatility.

68
00:07:01,000 --> 00:07:10,000
Do you see how the volatility, especially since late October, has been sliding downward?

69
00:07:10,000 --> 00:07:15,000
Less uncertainty, less volatility in the market.

70
00:07:15,000 --> 00:07:24,000
Now, professional investors and well-seasoned amateur investors don't like volatility.

71
00:07:24,000 --> 00:07:30,000
Volatility is not our friend. And so when that, we don't like uncertainty.

72
00:07:30,000 --> 00:07:39,000
So when the volatility of the overall market is declining, that's good news,

73
00:07:39,000 --> 00:07:44,000
because that's indicating more certainty about the future.

74
00:07:44,000 --> 00:07:48,000
Less disagreement. Bulls and bears pushing hard against each other.

75
00:07:48,000 --> 00:07:57,000
As that drains out, we are seeing a clearer path of expectations for the future.

76
00:07:57,000 --> 00:07:59,000
And that's what we're seeing here.

77
00:07:59,000 --> 00:08:03,000
We've seen a little bit of turbulence right here, but nothing to speak of.

78
00:08:03,000 --> 00:08:13,000
The overall trend over the past, since the end of October, has been downward in the volatility index, the VIX.

79
00:08:13,000 --> 00:08:22,000
More good news. More certainty. Less concern. Less volatility about what is coming next.

80
00:08:22,000 --> 00:08:31,000
And so all of these are pointing to the possibility that we are at least on the precipice of going from a recovery

81
00:08:31,000 --> 00:08:38,000
to a mild or decent expansion of the U.S. economy.

82
00:08:38,000 --> 00:08:44,000
Good news for you, because that means companies will have more confidence about new projects.

83
00:08:44,000 --> 00:08:48,000
They'll have more confidence about hiring for the future.

84
00:08:48,000 --> 00:08:52,000
And that's where you guys come in, for internships and jobs.

85
00:08:52,000 --> 00:08:55,000
So it doesn't have just abstract meaning.

86
00:08:55,000 --> 00:08:59,000
In the short run, it means better job prospects.

87
00:08:59,000 --> 00:09:06,000
In the longer run, it means that you'll be walking into an economy that is in good shape when you graduate.

88
00:09:06,000 --> 00:09:10,000
We hope. Unless all hell breaks loose somewhere.

89
00:09:10,000 --> 00:09:13,000
But for now, we're in good shape.

90
00:09:13,000 --> 00:09:28,000
Now, what I did, I have upgraded that project analysis worksheet that I gave you, that I uploaded from Monday's lecture.

91
00:09:28,000 --> 00:09:31,000
And I have now tuned it up.

92
00:09:31,000 --> 00:09:37,000
You can now change the number of years of the project life.

93
00:09:37,000 --> 00:09:46,000
And there's one thing you have to remember to do, but other than that, you can do projects of greater length than four years.

94
00:09:46,000 --> 00:09:49,000
Five years, six years, seven years, whatever you want.

95
00:09:49,000 --> 00:09:52,000
But here's the first part of it.

96
00:09:52,000 --> 00:09:55,000
Anything that's in gray, you don't touch.

97
00:09:55,000 --> 00:10:06,000
Anything that I would ask you, or that you get in the book's homework, would not throw a curveball from what we're doing here.

98
00:10:06,000 --> 00:10:13,000
So if I ask you on a quiz, or the final exam, just leave those numbers in gray alone.

99
00:10:13,000 --> 00:10:23,000
And the rest of them, as you can see, just like the lecture on Monday, you're going to have an equipment cost and a tax rate.

100
00:10:23,000 --> 00:10:27,000
You put those in. You just punch in the numbers that you need to punch in.

101
00:10:27,000 --> 00:10:33,000
Let me do something here.

102
00:10:33,000 --> 00:10:40,000
Didn't mean to do that. Let's get that back to that.

103
00:10:40,000 --> 00:10:46,000
And then you're going to put in your increase in inventory.

104
00:10:46,000 --> 00:10:52,000
In the project run-up, in the run-up year, year zero, you're going to add inventory.

105
00:10:52,000 --> 00:10:56,000
So that's going to be that number right there, inventory.

106
00:10:56,000 --> 00:10:58,000
And then the increase in accounts payable.

107
00:10:58,000 --> 00:11:03,000
You're going to start having to owe bills that you don't pay immediately.

108
00:11:03,000 --> 00:11:06,000
So the net will be that number.

109
00:11:06,000 --> 00:11:18,000
In this case, I start with $25,000 increase in inventory, and I increase the accounts payable increase by $5,000.

110
00:11:18,000 --> 00:11:22,000
So the net change, you don't have to calculate that.

111
00:11:22,000 --> 00:11:28,000
You see the formula beside it in case you're interested in knowing what I did.

112
00:11:28,000 --> 00:11:34,000
Now, let me fix this before I finally upload the newest version.

113
00:11:34,000 --> 00:11:38,000
Okay, so now sales, how many units of sale do you have?

114
00:11:38,000 --> 00:11:44,000
The price per unit, and this will be your gross revenue.

115
00:11:44,000 --> 00:11:47,000
You don't have to calculate it. It will calculate automatically.

116
00:11:47,000 --> 00:11:55,000
I'm trying to convince you that Excel, the more you get comfortable with it, the less work you actually have to do.

117
00:11:55,000 --> 00:11:59,000
You just have to put numbers in, and it will crank for you.

118
00:11:59,000 --> 00:12:02,000
Variable cost, 60%.

119
00:12:02,000 --> 00:12:07,000
Now the salvage value is $25,000.

120
00:12:07,000 --> 00:12:12,000
Okay, so what we'll have to do is the book value is zero.

121
00:12:12,000 --> 00:12:19,000
Now the book value, that's just going to be zero. I'll give you, do the ones with bonus depreciation.

122
00:12:19,000 --> 00:12:22,000
Okay, taxable salvage value.

123
00:12:22,000 --> 00:12:29,000
It'll be the sale price of the stuff, the salvage value, minus your book value.

124
00:12:29,000 --> 00:12:35,000
So in this case, if the salvage value is $25,000, you're going to sell it for $25,000 at the end of the project.

125
00:12:35,000 --> 00:12:47,000
You have depreciated away all book, so you're going to pay $25,000 minus zero, salvage minus book, and you get $25,000.

126
00:12:47,000 --> 00:12:50,000
You don't have to calculate it. It's done for you.

127
00:12:50,000 --> 00:13:01,000
And so your salvage value after taxes will be, that number right there, $18,750.

128
00:13:01,000 --> 00:13:07,000
$25,000 minus the tax on the $25,000.

129
00:13:07,000 --> 00:13:13,000
Now the project life, this is where you can modify it to whatever you want.

130
00:13:13,000 --> 00:13:18,000
In this case, I've got five years.

131
00:13:18,000 --> 00:13:25,000
Now I put in a weighted average cost of capital and a reinvestment rate.

132
00:13:25,000 --> 00:13:32,000
That would only come into play if you had more than one switch in the sign of the cash flows.

133
00:13:32,000 --> 00:13:40,000
So I've put it in there in case you would have to do it instead of an internal rate of return, a modified internal rate of return.

134
00:13:40,000 --> 00:13:50,000
And so I strongly encourage you to use the input sheet first and then see the results over here.

135
00:13:50,000 --> 00:13:58,000
As you can see, it automatically shifts the number of years from year zero to four,

136
00:13:58,000 --> 00:14:03,000
which was the original example we did on Monday, to zero to five.

137
00:14:03,000 --> 00:14:05,000
Watch what happens here.

138
00:14:05,000 --> 00:14:12,000
Suppose that I decide that I want a project life of six years.

139
00:14:12,000 --> 00:14:21,000
Watch. It automatically puts in a sixth year.

140
00:14:21,000 --> 00:14:26,000
Let me center those.

141
00:14:26,000 --> 00:14:35,000
And notice that all of these numbers adjust on their own.

142
00:14:35,000 --> 00:14:43,000
However, if they don't adjust on their own, I've got this one in a light shade of peach.

143
00:14:43,000 --> 00:14:45,000
It's one of my favorite colors.

144
00:14:45,000 --> 00:14:54,000
And you just put it on the peach colored one for year one, and you drag it down as far as you need.

145
00:14:54,000 --> 00:15:05,000
Drag it only as far as the ending year of the project with the little cross, and the numbers will go in on their own.

146
00:15:05,000 --> 00:15:08,000
But that would be if you changed the number of years.

147
00:15:08,000 --> 00:15:19,000
So for example, watch what would happen if I go to seven years.

148
00:15:19,000 --> 00:15:24,000
In this case, I'm going to drag it down.

149
00:15:24,000 --> 00:15:26,000
There you go.

150
00:15:26,000 --> 00:15:28,000
See what's happening?

151
00:15:28,000 --> 00:15:31,000
It's fixing itself. It's healing itself.

152
00:15:31,000 --> 00:15:42,000
Now if you go to a shorter number of years, like you can go to, let's say, back to five years,

153
00:15:42,000 --> 00:15:48,000
what you would do is you could remove the last two.

154
00:15:48,000 --> 00:15:53,000
They're already wiped out.

155
00:15:53,000 --> 00:16:04,000
And the NPV, internal rate of return, and the modified internal rate of return, autocalculate.

156
00:16:04,000 --> 00:16:14,000
Again, the only thing you have to remember to do is to take that year one and copy it down the number of years of the project.

157
00:16:14,000 --> 00:16:22,000
To do that automatically, I would have to write, the way I see to do it would be to write a macro.

158
00:16:22,000 --> 00:16:33,000
And then every time you try to upload a sheet or send a sheet that has macros in it, the servers don't let you do it.

159
00:16:33,000 --> 00:16:37,000
So that's one thing you'll have to remember to do.

160
00:16:37,000 --> 00:16:40,000
But everything else is automated.

161
00:16:40,000 --> 00:16:50,000
All you have to do is pump in the numbers in the white cells, and the rest of it fixes on its own.

162
00:16:50,000 --> 00:16:53,000
All for you.

163
00:16:53,000 --> 00:17:00,000
And that should make it a lot faster for you to do this on a quiz or the final exam.

164
00:17:00,000 --> 00:17:08,000
Now while I would ask my quiz or the final exam will fit into this framework just really elegantly,

165
00:17:08,000 --> 00:17:12,000
I just have to pull the numbers out of the narrow test and put them in the right places.

166
00:17:12,000 --> 00:17:17,000
Just like in the bond calculations.

167
00:17:17,000 --> 00:17:20,000
Okay, enough of that.

168
00:17:20,000 --> 00:17:25,000
So that's there. Let me save that.

169
00:17:25,000 --> 00:17:30,000
And upload it.

170
00:17:30,000 --> 00:17:39,000
Before I forget.

171
00:17:39,000 --> 00:17:41,000
Something's weird here.

172
00:17:41,000 --> 00:17:46,000
Downloads.

173
00:17:46,000 --> 00:17:50,000
Why is it I saved that?

174
00:17:50,000 --> 00:17:52,000
Let me try it again.

175
00:17:52,000 --> 00:17:54,000
Cancel.

176
00:17:54,000 --> 00:17:57,000
Okay, let me upload that again.

177
00:17:57,000 --> 00:18:00,000
There, 445.

178
00:18:00,000 --> 00:18:06,000
Why is it not recognizing downloads?

179
00:18:06,000 --> 00:18:08,000
Cancel.

180
00:18:08,000 --> 00:18:11,000
Let me save it one more time.

181
00:18:11,000 --> 00:18:13,000
File.

182
00:18:13,000 --> 00:18:16,000
Save.

183
00:18:16,000 --> 00:18:21,000
Now let me see if it looks right now.

184
00:18:21,000 --> 00:18:24,000
My downloads, project analysis at 356.

185
00:18:24,000 --> 00:18:27,000
I'm good now.

186
00:18:27,000 --> 00:18:32,000
Okay, so now I'm just going to put it up there so I don't have to worry about it.

187
00:18:32,000 --> 00:18:35,000
Uploads, project analysis.

188
00:18:35,000 --> 00:18:38,000
There it is.

189
00:18:38,000 --> 00:18:40,000
Nice, the old one.

190
00:18:40,000 --> 00:18:43,000
And now you can play with it, change the numbers just so you're comfortable.

191
00:18:43,000 --> 00:18:53,000
I strongly recommend that you do that just so you don't wonder what's what when you get to the question like this on the exam.

192
00:18:53,000 --> 00:18:58,000
Enough of that.

193
00:18:58,000 --> 00:19:00,000
I'll get rid of this one.

194
00:19:00,000 --> 00:19:06,000
Now I'm going to show you one last thing.

195
00:19:06,000 --> 00:19:13,000
Sometimes you have projects where the...

196
00:19:13,000 --> 00:19:19,000
You have a couple projects that are possible, but you can't do both of them.

197
00:19:19,000 --> 00:19:23,000
You have to choose one.

198
00:19:23,000 --> 00:19:30,000
Well, if you ran NPV analysis, if one of them is negative and one is positive, it's obvious.

199
00:19:30,000 --> 00:19:32,000
You should choose the better one.

200
00:19:32,000 --> 00:19:42,000
But sometimes you have a situation where you have two positive NPVs and something strange happens.

201
00:19:42,000 --> 00:19:49,000
Well, ideally, any positive NPV project, you should accept it.

202
00:19:49,000 --> 00:19:55,000
But in a case where you don't, let me give you an example of this, one from my own experience.

203
00:19:55,000 --> 00:20:02,000
There was a company, it wasn't anything huge, but it was underway and it was doing well.

204
00:20:02,000 --> 00:20:04,000
It had been running for about six years.

205
00:20:04,000 --> 00:20:10,000
And they were kind of bursting at the seams on office space.

206
00:20:10,000 --> 00:20:13,000
And they had a piece of land.

207
00:20:13,000 --> 00:20:15,000
They had a piece of land in town.

208
00:20:15,000 --> 00:20:30,000
And, well, we could put a new office up there and use our existing office space as for some of the satellite for the salespeople and all that.

209
00:20:30,000 --> 00:20:36,000
However, they also were in need of a manufacturing facility.

210
00:20:36,000 --> 00:20:42,000
Because they had been getting everything as imports and they wanted to start doing the build.

211
00:20:42,000 --> 00:20:44,000
It wasn't some fancy thing.

212
00:20:44,000 --> 00:20:50,000
It was more like get the imports and then finish putting them together here in the United States.

213
00:20:50,000 --> 00:20:57,000
So they could have used that land, they could use that land for this production facility.

214
00:20:57,000 --> 00:21:00,000
They can't use it for both of them.

215
00:21:00,000 --> 00:21:02,000
They'd have to use it for one.

216
00:21:02,000 --> 00:21:07,000
And so they had to make a decision on which one.

217
00:21:07,000 --> 00:21:10,000
They were both positive NPV projects.

218
00:21:10,000 --> 00:21:12,000
But here's what happens.

219
00:21:12,000 --> 00:21:19,000
Sometimes you have project A and you have project B.

220
00:21:19,000 --> 00:21:25,000
Now the NPV, and I'll just do some abstract numbers, some pull them out of my head.

221
00:21:25,000 --> 00:21:29,000
Internal rate of return, NPV and internal rate of return.

222
00:21:29,000 --> 00:21:40,000
Project A, let's say it has a positive NPV of $2,900.

223
00:21:40,000 --> 00:21:48,000
Project B has an NPV of $2,450.

224
00:21:48,000 --> 00:21:51,000
Well, if they're mutually exclusive, your choice is obvious.

225
00:21:51,000 --> 00:21:52,000
You would take A.

226
00:21:52,000 --> 00:22:02,000
But the internal rate of return of project A is 7.58%.

227
00:22:02,000 --> 00:22:12,000
The internal rate of return of project B is 9.87%.

228
00:22:12,000 --> 00:22:17,000
Oh my, they're giving conflicting results.

229
00:22:17,000 --> 00:22:20,000
NPV tells you take project A.

230
00:22:20,000 --> 00:22:25,000
Internal rate of return tells you to take project B.

231
00:22:25,000 --> 00:22:30,000
So you are in a difficult situation here.

232
00:22:30,000 --> 00:22:38,000
How do you decide which one to do?

233
00:22:38,000 --> 00:22:43,000
The popular way, and I'll mention it another way, and they go through it in the book.

234
00:22:43,000 --> 00:22:52,000
The popular way is to use an approach called equivalent lives.

235
00:22:52,000 --> 00:22:56,000
The equivalent life method is the one I'm showing you here,

236
00:22:56,000 --> 00:23:01,000
and I strongly recommend that you pull out your Excel

237
00:23:01,000 --> 00:23:05,000
or at least write these numbers down so that you can do this yourself.

238
00:23:05,000 --> 00:23:14,000
And I'll upload this one to the file spreadsheets in Canvas.

239
00:23:14,000 --> 00:23:21,000
But I encourage you to put these numbers in.

240
00:23:21,000 --> 00:23:28,000
What you see right here is project A.

241
00:23:28,000 --> 00:23:31,000
And we'll look at a project B here in a minute.

242
00:23:31,000 --> 00:23:36,000
But project A, it's cash flow, free cash flow.

243
00:23:36,000 --> 00:23:40,000
Year 0 is negative $30,000.

244
00:23:40,000 --> 00:23:43,000
Year 1 is $6,000.

245
00:23:43,000 --> 00:23:46,000
Year 2 is $10,000.

246
00:23:46,000 --> 00:23:49,000
Year 3 is $12,000.

247
00:23:49,000 --> 00:23:52,000
Year 4 is $8,000.

248
00:23:52,000 --> 00:23:55,000
Year 5 is $4,000.

249
00:23:55,000 --> 00:24:05,000
And year 6 is $7,000.

250
00:24:05,000 --> 00:24:11,000
And we have a weighted average cost of capital of 8%

251
00:24:11,000 --> 00:24:16,000
and a reinvestment rate of 12%.

252
00:24:16,000 --> 00:24:23,000
So what I'm about to do, you will probably need to have the reinvestment rate

253
00:24:23,000 --> 00:24:30,000
because there's going to be a cash flow that turns negative to positive

254
00:24:30,000 --> 00:24:35,000
and then later turns positive to negative and then back from negative to positive,

255
00:24:35,000 --> 00:24:43,000
which means that the normal internal rate of return won't have any meaning.

256
00:24:43,000 --> 00:24:49,000
For this one, you don't use the MIRR because it's just a single project,

257
00:24:49,000 --> 00:24:53,000
one change in the sign of the cash flow, free cash flow,

258
00:24:53,000 --> 00:24:58,000
so you're all in business with just the weighted average cost of capital, 8%.

259
00:24:58,000 --> 00:25:04,000
And you do your net present value, just the old school,

260
00:25:04,000 --> 00:25:15,000
equals the initial investment plus NPV of the free cash flow for years 1 through,

261
00:25:15,000 --> 00:25:20,000
in this case, 6.

262
00:25:20,000 --> 00:25:30,000
And so you find that the net present value of Project A is $6,669

263
00:25:30,000 --> 00:25:38,000
with a nice spanking internal rate of return of 15.33%.

264
00:25:38,000 --> 00:25:48,000
Obviously, if all there is, all you're looking at is Project A, this is a go.

265
00:25:48,000 --> 00:26:15,000
But now let's look at a second project, Project B.

266
00:26:15,000 --> 00:26:19,000
Try that one more time.

267
00:26:19,000 --> 00:26:30,000
Project B.

268
00:26:30,000 --> 00:26:41,000
Now in Project B, something interesting is going to happen here.

269
00:26:41,000 --> 00:26:52,000
First of all, let me hide this just for a second so you can see something.

270
00:26:52,000 --> 00:27:03,000
Now Project B will have a net present value of $3,734.

271
00:27:03,000 --> 00:27:08,000
The NPV of Project B is below the NPV of Project A,

272
00:27:08,000 --> 00:27:18,000
but the internal rate of return of Project B is higher than the internal rate of return of Project A,

273
00:27:18,000 --> 00:27:25,000
which means that if you take it NPV, you go A.

274
00:27:25,000 --> 00:27:35,000
If you take it internal rate of return, you go Project B, if they're mutually exclusive projects.

275
00:27:35,000 --> 00:27:42,000
So what's a mother to do in a situation like that?

276
00:27:42,000 --> 00:27:49,000
The most popular method is called equivalent lives.

277
00:27:49,000 --> 00:28:01,000
We see that Project C is $25,000 out to begin with, then $12,000 in for year one,

278
00:28:01,000 --> 00:28:09,000
$15,000 for period two, and $6,000 for period three.

279
00:28:09,000 --> 00:28:17,000
It's three years long. Project A is six years long.

280
00:28:17,000 --> 00:28:27,000
So the trick here is to say, what if we do Project B twice?

281
00:28:27,000 --> 00:28:39,000
We overlap Project B so that we have the same number of years that Project B is running that Project A would be running.

282
00:28:39,000 --> 00:28:51,000
So what we would do in this case is we would say, okay, Project B is winding down in year three.

283
00:28:51,000 --> 00:29:00,000
Let's do it again.

284
00:29:00,000 --> 00:29:17,000
Starting, try that again.

285
00:29:17,000 --> 00:29:21,000
Well, I give up.

286
00:29:21,000 --> 00:29:27,000
Starting in year three, we're going to do the very same project.

287
00:29:27,000 --> 00:29:36,000
Do you see how Project B has negative $25,000, $12,000, $15,000, $6,000?

288
00:29:36,000 --> 00:29:48,000
And then in year three, we're going to do it again and realize the same cash flows from year three to year six,

289
00:29:48,000 --> 00:29:52,000
so that the two projects have equivalent lives.

290
00:29:52,000 --> 00:30:02,000
We can do Project A once for six years, or we can do Project B twice for six years.

291
00:30:02,000 --> 00:30:20,000
So in order to do that, we are going to need to have the original free cash flows for Project B for years zero through three.

292
00:30:20,000 --> 00:30:33,000
But then we are going to go back and spend the $25,000 again in year three and run it over again

293
00:30:33,000 --> 00:30:45,000
so that the same cash flows that occurred in years zero through three also occur in years three through six.

294
00:30:45,000 --> 00:30:57,000
So all you do is copy from the first and paste it over into the next column down where you want to start the project again.

295
00:30:57,000 --> 00:31:08,000
So what the free cash flow of Project B turns into is the sum of the two free cash flows of the first time you did it

296
00:31:08,000 --> 00:31:10,000
and the second time you did it.

297
00:31:10,000 --> 00:31:20,000
So for Project B, the new way to look at the cash flow is, okay, year zero, you spend $25,000.

298
00:31:20,000 --> 00:31:24,000
Year one, you get $12,000 in.

299
00:31:24,000 --> 00:31:27,000
Year two, you get the $15,000 in.

300
00:31:27,000 --> 00:31:36,000
But in year three, you get $6,000 minus, you're going to do it over, minus the $25,000.

301
00:31:36,000 --> 00:31:45,000
So the net is you're down in year three to $19,000.

302
00:31:45,000 --> 00:31:51,000
And then in year four, you're just repeating, you're reliving the dream.

303
00:31:51,000 --> 00:31:57,000
$12,000, $15,000, $6,000, just like happened the first time.

304
00:31:57,000 --> 00:32:12,000
So the new profile for the new free cash flow profile from year zero to six is $25,000 down, negative,

305
00:32:12,000 --> 00:32:19,000
then $12,000, then $15,000, and then negative $19,000.

306
00:32:19,000 --> 00:32:32,000
And then you're back up, you've got $12,000, just like you did the first time, $15,000, and $6,000.

307
00:32:32,000 --> 00:32:37,000
And you do the overlap, where do you start the new one?

308
00:32:37,000 --> 00:32:46,000
Wherever it will end so that it has the equivalent years of the Project A.

309
00:32:46,000 --> 00:32:54,000
So if for five years I would have put it up here, just started it up here, put it up here,

310
00:32:54,000 --> 00:32:57,000
if this had been a five-year Project A, had been a five-year Project,

311
00:32:57,000 --> 00:33:05,000
I would have put the repeat of Project B up here, starting here, so that they end at the same time.

312
00:33:05,000 --> 00:33:07,000
That's all you do.

313
00:33:07,000 --> 00:33:12,000
And this spreadsheet that I'm showing you here will do it automatically.

314
00:33:12,000 --> 00:33:18,000
All you have to do is repeat the original free cash flows.

315
00:33:18,000 --> 00:33:20,000
That's all you have to do.

316
00:33:20,000 --> 00:33:27,000
Putting them in the place so that the last one occurs at the same time as the last one in Project A.

317
00:33:27,000 --> 00:33:44,000
And then this column, the year equivalent column, will calculate on its own.

318
00:33:44,000 --> 00:33:56,000
Now you notice something really odd happens.

319
00:33:56,000 --> 00:34:02,000
The NPV looks nasty on it.

320
00:34:02,000 --> 00:34:04,000
Yeah, it does, as a matter of fact.

321
00:34:04,000 --> 00:34:08,000
Boy, that's a nasty negative.

322
00:34:08,000 --> 00:34:12,000
But look at this.

323
00:34:12,000 --> 00:34:19,000
You kind of ignore the internal rate of return because it doesn't mean anything.

324
00:34:19,000 --> 00:34:28,000
As a matter of fact, let me fix that right now.

325
00:34:28,000 --> 00:34:34,000
Ah, better not, better not even try that.

326
00:34:34,000 --> 00:34:40,000
Notice now we have a modified internal rate of return.

327
00:34:40,000 --> 00:34:55,000
And notice now that Project B sucks both NPV and IRR, modified internal rate of return.

328
00:34:55,000 --> 00:35:05,000
The NPV of Project B on a year equivalent basis is negative $18,800.

329
00:35:05,000 --> 00:35:15,000
And the modified internal rate of return, which is what you would look at because of the switch in sign, is only 12.81%.

330
00:35:15,000 --> 00:35:25,000
So that advantage it had in the first pass disappears when you do it on a year equivalent basis.

331
00:35:25,000 --> 00:35:31,000
So Project A is the go project.

332
00:35:31,000 --> 00:35:45,000
The only reason that the internal rate of return of Project B was so good was because it was a quick blast project.

333
00:35:45,000 --> 00:35:47,000
It wasn't a long haul.

334
00:35:47,000 --> 00:36:05,000
In the long haul, if you had to repeat Project B to get as much punch as you get a number of years of life as Project A, Project B is not good.

335
00:36:05,000 --> 00:36:09,000
It was only good because it was shorter.

336
00:36:09,000 --> 00:36:16,000
But when you look at it in the same time frame as Project A, it's no good.

337
00:36:16,000 --> 00:36:29,000
It looks complicated at first, but really all you have to do for a problem like this is just key in the numbers for Projects A and B,

338
00:36:29,000 --> 00:36:37,000
and then copy those cash flows over so that you've got year equivalents.

339
00:36:37,000 --> 00:36:41,000
You've got the same number of years.

340
00:36:41,000 --> 00:36:43,000
That's all there is.

341
00:36:43,000 --> 00:36:46,000
And then everything else will spit out for you.

342
00:36:46,000 --> 00:37:02,000
And for the year equivalent, you look at the modified internal rate of return versus the just straight internal rate of return of Project A.

343
00:37:02,000 --> 00:37:04,000
Just play with it.

344
00:37:04,000 --> 00:37:08,000
You'll get the hang of it.

345
00:37:08,000 --> 00:37:14,000
Let me save as browse.

346
00:37:14,000 --> 00:37:33,000
I'll just put this in downloads and call it Projects Mutually Exclusive.

347
00:37:33,000 --> 00:37:38,000
And then I'm going to upload it to Canvas so I don't forget to do it.

348
00:37:38,000 --> 00:37:41,000
And of course I went out of Canvas, so here we go again.

349
00:37:41,000 --> 00:37:45,000
Got to go in and do it over again.

350
00:37:45,000 --> 00:37:59,000
Go over to the files, spreadsheets, upload, and look at my downloads.

351
00:37:59,000 --> 00:38:01,000
I put it there.

352
00:38:01,000 --> 00:38:03,000
And there you go.

353
00:38:03,000 --> 00:38:06,000
It's all yours.

354
00:38:06,000 --> 00:38:15,000
Now there's one last part of this story.

355
00:38:15,000 --> 00:38:22,000
And this would not really have been much of an issue 20 years ago.

356
00:38:22,000 --> 00:38:31,000
Certainly, I can't imagine talking much about it back 40 years ago when I was a young teacher.

357
00:38:31,000 --> 00:38:34,000
But here's something.

358
00:38:34,000 --> 00:38:46,000
A lot of companies are facing a rather nasty decision with respect to technological growth, technological improvements.

359
00:38:46,000 --> 00:39:05,000
You can go with an equipment, let's say a computer purchase, where it's cheaper but the life of the computers is maybe only three years.

360
00:39:05,000 --> 00:39:14,000
Or you could go more expensive with computers that are future-proofed and they might last you six years.

361
00:39:14,000 --> 00:39:18,000
Hell, some of the places I've taught, they lasted 10 years.

362
00:39:18,000 --> 00:39:20,000
But it's a real decision.

363
00:39:20,000 --> 00:39:26,000
Do you go cheap and then have to replace them in a few years?

364
00:39:26,000 --> 00:39:34,000
Or do you go expensive and not need to replace them for a much longer time period?

365
00:39:34,000 --> 00:39:42,000
And this is happening especially with computers, but it's also happening in this era of electric vehicles.

366
00:39:42,000 --> 00:39:55,000
You see, if I buy, if my company buys a fleet of, I want to replace my fleet, if I replace the fleet with fossil fuel burner,

367
00:39:55,000 --> 00:40:06,000
just old-fashioned diesel engine, newest versions, those will last seven, eight, 10 years.

368
00:40:06,000 --> 00:40:10,000
Notwithstanding any virtue legislation, I should point out.

369
00:40:10,000 --> 00:40:14,000
But, or I could go with electric vehicles.

370
00:40:14,000 --> 00:40:20,000
Now electric vehicles are definitely going to be improving.

371
00:40:20,000 --> 00:40:23,000
Right now they actually kind of suck.

372
00:40:23,000 --> 00:40:30,000
They have very short haul mileage, especially if they're pulling big loads.

373
00:40:30,000 --> 00:40:40,000
The batteries will improve in efficiency and they will also improve in terms of weight.

374
00:40:40,000 --> 00:40:44,000
And this is going to happen over the next three to five years.

375
00:40:44,000 --> 00:40:53,000
So in other words, if I buy electric vehicles, I will probably really want to replace those within about four years.

376
00:40:53,000 --> 00:40:59,000
Because the ones that are coming online in four years are going to be so much more efficient.

377
00:40:59,000 --> 00:41:05,000
They'll haul much bigger loads and they will have much lower weight on the batteries in them.

378
00:41:05,000 --> 00:41:15,000
Or I can buy just some big old-fashioned diesel trucks and they'll last me for another, they'll go for 10 years.

379
00:41:15,000 --> 00:41:19,000
So the decision has to be like that.

380
00:41:19,000 --> 00:41:23,000
Now there's another way you can do it and they talk about it in the book, show you some examples.

381
00:41:23,000 --> 00:41:29,000
But classically this would be a mutually exclusive thing.

382
00:41:29,000 --> 00:41:35,000
Either you buy the new technology, which you will have to replace in four years,

383
00:41:35,000 --> 00:41:44,000
or you go with an older technology, which will probably be more expensive comparatively speaking,

384
00:41:44,000 --> 00:41:48,000
but it will last you for a longer, much longer time.

385
00:41:48,000 --> 00:41:53,000
And you're seeing that in a lot of different places, even in consumer electronics.

386
00:41:53,000 --> 00:42:01,000
And it's actually almost the perverse of it.

387
00:42:01,000 --> 00:42:06,000
In marketing, did they talk to you about what are called early adopters?

388
00:42:06,000 --> 00:42:14,000
Okay, this is really, really something in mobile phones.

389
00:42:14,000 --> 00:42:20,000
The classic example now being Samsung, which came out three years ago or four years ago

390
00:42:20,000 --> 00:42:24,000
with the first fold and or flip phones.

391
00:42:24,000 --> 00:42:27,000
And the technologies just sucked.

392
00:42:27,000 --> 00:42:35,000
The face of them would crease, it would crack, but, and they were ridiculously expensive.

393
00:42:35,000 --> 00:42:45,000
What we rely on is early adopters, the people who just have to have the newest and best.

394
00:42:45,000 --> 00:42:50,000
Knowing as we do that with technologies like this, two things are going to happen.

395
00:42:50,000 --> 00:42:55,000
One, the design is going to improve from one generation to the next of the phones.

396
00:42:55,000 --> 00:42:56,000
What are we now in?

397
00:42:56,000 --> 00:43:03,000
Generation four of the Samsung, generation five of the Motorola Flips or something like that.

398
00:43:03,000 --> 00:43:08,000
Okay, and then another thing that's going to come online, competition.

399
00:43:08,000 --> 00:43:15,000
There will be producers who will just sit back and let the big dogs tear each other up

400
00:43:15,000 --> 00:43:21,000
and get all kinds of bad reputation for these early technology phones that don't work very well.

401
00:43:21,000 --> 00:43:25,000
And then they'll come in once the technology has improved,

402
00:43:25,000 --> 00:43:30,000
and they will force everyone to drop their prices.

403
00:43:30,000 --> 00:43:36,000
As we're seeing now, especially with Motorola, but even Samsung is doing it now too.

404
00:43:36,000 --> 00:43:41,000
So there is another odd example of what happens.

405
00:43:41,000 --> 00:43:47,000
Technologies that you have to replace very early, within a couple of years,

406
00:43:47,000 --> 00:43:51,000
or technologies that last much longer.

407
00:43:51,000 --> 00:43:56,000
And so we're seeing these kinds, the technological age that we're in now

408
00:43:56,000 --> 00:44:00,000
is bringing up more and more of these mutually exclusive projects,

409
00:44:00,000 --> 00:44:05,000
where even in our daily lives we have to make some kind of an internal,

410
00:44:05,000 --> 00:44:09,000
net present value internal rate of return calculation,

411
00:44:09,000 --> 00:44:15,000
although we probably don't do it formally, we're still thinking about it.

412
00:44:15,000 --> 00:44:19,000
The lesson is, let the early adopters buy the technology,

413
00:44:19,000 --> 00:44:24,000
and then you buy it after it's cheaper and less expensive.

414
00:44:24,000 --> 00:44:26,000
That's all I have for you today, I thank you.