Allen Kring Productions in association with the Emergent Light Studio presents
the Illinois State Collegiate Compendium, Academic Lecturing in Business and Economics.
This is Business Finance, FIL 240 for autumn semester 2023.
Today, extensions of free cash flow analysis.
A few things to start off our happy time together.
I was going to give you a little surprise quiz today,
but I've got so many people who've gotten notices from the dean that they're sick
that I decided I wouldn't give a pop quiz because I don't want my tires slashed on my car.
So this will actually be a little bit shorter lecture because the time allocated for the quiz
is now time that I would have to figure out some improv, and I'm not very good at that right now.
So as we usually do, we'll have a look at the numbers, and the numbers are there.
And it's kind of an interesting day because usually it's the opposite of this,
but today the Dow is up the most, almost a half a percent.
The S&P 500 is up less, at.18,.16 percent,
and then the NASDAQ groveled along and got a lousy.7 percent.
On the bright side, it's bullish.
Clearly there's a broad sentiment of positivity, and part of that is it was sort of suspected.
So a lot of this price was impounded, good news price was impounded over the past couple of days,
but we've now been, the official numbers are in, that wholesale prices went down last month.
It was a negative on the PPI, which is a strong evidence that we are now bringing inflation under control,
and we are hopeful that in the next couple of months we'll see retail prices follow suit.
And that would be good news because we're going into the Christmas season.
If you've got prices going down, you're going to get a lot more sales,
and so that will boost Christmas spending and give us a good juicer going into the next year.
We may be moving then from recovery into a decent little expansion of the economy,
which is good news for everybody and for you with jobs and all that, as I've said before.
So, but it wasn't really spectacular.
The market's reaction wasn't spectacular, first of all because this was expected,
so the price has already reacted nicely to that.
And then also, they're still looking at the volume on the S&P 500.
There was a spike of volume at the end.
You see that volume bar just really raced upward there at the end,
but overall it was still a lousy day compared to the 52-week daily average.
We had about 2.5 billion shares versus 3.7 billion shares a year ago today.
Well, I'm sorry, yeah, the average a year ago.
So we don't have a lot to celebrate.
The heavy money is still staying off the playing field for the time being.
But going back to the numbers here on the top drawer, we've got the crude oil coming down,
and that should push prices of gasoline down.
They're still unusually high compared to what they were when the price of oil was higher than it is now,
but we should see that backing off within the week or so.
And then over here, a little bit notable on the bond market is that bond yields surged upward,
but they eased off there at the end.
Most likely, even though we are pretty sure the Fed isn't going to raise interest rates now,
at least for the foreseeable future because of the positive inflation numbers,
what we probably saw was bond investors selling out of bonds, driving their prices down and the yields up,
and moving at least some of that money into equities,
hence equity prices going up while bond prices are going down and yields are going up.
So there's that.
The gold bugs, they were a little excited. They surged for a while, but then they gave up.
They decided the world isn't going into an economic apocalypse, so gold isn't an issue.
Now, the euro, the pound, and the yen all depreciated against the dollar today.
Stronger dollar, that's good news. Stronger dollar means cheaper imports.
And we're going into the Christmas season, and a lot of what we buy are imports,
and they will have lower prices. All good news for us.
On the other side of the world, last night, the Nikkei just had a long, slow grinding push upward,
finishing off a very smooth bull market for the day, up about 2.5%.
That's good news. And then over in London, it's still volatile, but at least it stayed positive today.
Bullish over in London, and then that sentiment seems to have come across the Atlantic,
and here we are, decent day on Wall Street. So there's that.
Let me show you one thing. I had shown you this several months, or more than a month ago.
I showed you the VIX. The VIX is a raw measure of market volatility.
Higher volatility, higher risk. The market is, well, let's look at the VIX right now.
The VIX was up a tiny bit, but overall, if you look at the VIX over the last, let's say,
oh, six months or so, or a year maybe?
One month. Let's look at the one month. That's a good one.
Notice how the VIX, measuring volatility.
Do you see how the volatility, especially since late October, has been sliding downward?
Less uncertainty, less volatility in the market.
Now, professional investors and well-seasoned amateur investors don't like volatility.
Volatility is not our friend. And so when that, we don't like uncertainty.
So when the volatility of the overall market is declining, that's good news,
because that's indicating more certainty about the future.
Less disagreement. Bulls and bears pushing hard against each other.
As that drains out, we are seeing a clearer path of expectations for the future.
And that's what we're seeing here.
We've seen a little bit of turbulence right here, but nothing to speak of.
The overall trend over the past, since the end of October, has been downward in the volatility index, the VIX.
More good news. More certainty. Less concern. Less volatility about what is coming next.
And so all of these are pointing to the possibility that we are at least on the precipice of going from a recovery
to a mild or decent expansion of the U.S. economy.
Good news for you, because that means companies will have more confidence about new projects.
They'll have more confidence about hiring for the future.
And that's where you guys come in, for internships and jobs.
So it doesn't have just abstract meaning.
In the short run, it means better job prospects.
In the longer run, it means that you'll be walking into an economy that is in good shape when you graduate.
We hope. Unless all hell breaks loose somewhere.
But for now, we're in good shape.
Now, what I did, I have upgraded that project analysis worksheet that I gave you, that I uploaded from Monday's lecture.
And I have now tuned it up.
You can now change the number of years of the project life.
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.
Five years, six years, seven years, whatever you want.
But here's the first part of it.
Anything that's in gray, you don't touch.
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.
So if I ask you on a quiz, or the final exam, just leave those numbers in gray alone.
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.
You put those in. You just punch in the numbers that you need to punch in.
Let me do something here.
Didn't mean to do that. Let's get that back to that.
And then you're going to put in your increase in inventory.
In the project run-up, in the run-up year, year zero, you're going to add inventory.
So that's going to be that number right there, inventory.
And then the increase in accounts payable.
You're going to start having to owe bills that you don't pay immediately.
So the net will be that number.
In this case, I start with $25,000 increase in inventory, and I increase the accounts payable increase by $5,000.
So the net change, you don't have to calculate that.
You see the formula beside it in case you're interested in knowing what I did.
Now, let me fix this before I finally upload the newest version.
Okay, so now sales, how many units of sale do you have?
The price per unit, and this will be your gross revenue.
You don't have to calculate it. It will calculate automatically.
I'm trying to convince you that Excel, the more you get comfortable with it, the less work you actually have to do.
You just have to put numbers in, and it will crank for you.
Variable cost, 60%.
Now the salvage value is $25,000.
Okay, so what we'll have to do is the book value is zero.
Now the book value, that's just going to be zero. I'll give you, do the ones with bonus depreciation.
Okay, taxable salvage value.
It'll be the sale price of the stuff, the salvage value, minus your book value.
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.
You have depreciated away all book, so you're going to pay $25,000 minus zero, salvage minus book, and you get $25,000.
You don't have to calculate it. It's done for you.
And so your salvage value after taxes will be, that number right there, $18,750.
$25,000 minus the tax on the $25,000.
Now the project life, this is where you can modify it to whatever you want.
In this case, I've got five years.
Now I put in a weighted average cost of capital and a reinvestment rate.
That would only come into play if you had more than one switch in the sign of the cash flows.
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.
And so I strongly encourage you to use the input sheet first and then see the results over here.
As you can see, it automatically shifts the number of years from year zero to four,
which was the original example we did on Monday, to zero to five.
Watch what happens here.
Suppose that I decide that I want a project life of six years.
Watch. It automatically puts in a sixth year.
Let me center those.
And notice that all of these numbers adjust on their own.
However, if they don't adjust on their own, I've got this one in a light shade of peach.
It's one of my favorite colors.
And you just put it on the peach colored one for year one, and you drag it down as far as you need.
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.
But that would be if you changed the number of years.
So for example, watch what would happen if I go to seven years.
In this case, I'm going to drag it down.
There you go.
See what's happening?
It's fixing itself. It's healing itself.
Now if you go to a shorter number of years, like you can go to, let's say, back to five years,
what you would do is you could remove the last two.
They're already wiped out.
And the NPV, internal rate of return, and the modified internal rate of return, autocalculate.
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.
To do that automatically, I would have to write, the way I see to do it would be to write a macro.
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.
So that's one thing you'll have to remember to do.
But everything else is automated.
All you have to do is pump in the numbers in the white cells, and the rest of it fixes on its own.
All for you.
And that should make it a lot faster for you to do this on a quiz or the final exam.
Now while I would ask my quiz or the final exam will fit into this framework just really elegantly,
I just have to pull the numbers out of the narrow test and put them in the right places.
Just like in the bond calculations.
Okay, enough of that.
So that's there. Let me save that.
And upload it.
Before I forget.
Something's weird here.
Downloads.
Why is it I saved that?
Let me try it again.
Cancel.
Okay, let me upload that again.
There, 445.
Why is it not recognizing downloads?
Cancel.
Let me save it one more time.
File.
Save.
Now let me see if it looks right now.
My downloads, project analysis at 356.
I'm good now.
Okay, so now I'm just going to put it up there so I don't have to worry about it.
Uploads, project analysis.
There it is.
Nice, the old one.
And now you can play with it, change the numbers just so you're comfortable.
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.
Enough of that.
I'll get rid of this one.
Now I'm going to show you one last thing.
Sometimes you have projects where the...
You have a couple projects that are possible, but you can't do both of them.
You have to choose one.
Well, if you ran NPV analysis, if one of them is negative and one is positive, it's obvious.
You should choose the better one.
But sometimes you have a situation where you have two positive NPVs and something strange happens.
Well, ideally, any positive NPV project, you should accept it.
But in a case where you don't, let me give you an example of this, one from my own experience.
There was a company, it wasn't anything huge, but it was underway and it was doing well.
It had been running for about six years.
And they were kind of bursting at the seams on office space.
And they had a piece of land.
They had a piece of land in town.
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.
However, they also were in need of a manufacturing facility.
Because they had been getting everything as imports and they wanted to start doing the build.
It wasn't some fancy thing.
It was more like get the imports and then finish putting them together here in the United States.
So they could have used that land, they could use that land for this production facility.
They can't use it for both of them.
They'd have to use it for one.
And so they had to make a decision on which one.
They were both positive NPV projects.
But here's what happens.
Sometimes you have project A and you have project B.
Now the NPV, and I'll just do some abstract numbers, some pull them out of my head.
Internal rate of return, NPV and internal rate of return.
Project A, let's say it has a positive NPV of $2,900.
Project B has an NPV of $2,450.
Well, if they're mutually exclusive, your choice is obvious.
You would take A.
But the internal rate of return of project A is 7.58%.
The internal rate of return of project B is 9.87%.
Oh my, they're giving conflicting results.
NPV tells you take project A.
Internal rate of return tells you to take project B.
So you are in a difficult situation here.
How do you decide which one to do?
The popular way, and I'll mention it another way, and they go through it in the book.
The popular way is to use an approach called equivalent lives.
The equivalent life method is the one I'm showing you here,
and I strongly recommend that you pull out your Excel
or at least write these numbers down so that you can do this yourself.
And I'll upload this one to the file spreadsheets in Canvas.
But I encourage you to put these numbers in.
What you see right here is project A.
And we'll look at a project B here in a minute.
But project A, it's cash flow, free cash flow.
Year 0 is negative $30,000.
Year 1 is $6,000.
Year 2 is $10,000.
Year 3 is $12,000.
Year 4 is $8,000.
Year 5 is $4,000.
And year 6 is $7,000.
And we have a weighted average cost of capital of 8%
and a reinvestment rate of 12%.
So what I'm about to do, you will probably need to have the reinvestment rate
because there's going to be a cash flow that turns negative to positive
and then later turns positive to negative and then back from negative to positive,
which means that the normal internal rate of return won't have any meaning.
For this one, you don't use the MIRR because it's just a single project,
one change in the sign of the cash flow, free cash flow,
so you're all in business with just the weighted average cost of capital, 8%.
And you do your net present value, just the old school,
equals the initial investment plus NPV of the free cash flow for years 1 through,
in this case, 6.
And so you find that the net present value of Project A is $6,669
with a nice spanking internal rate of return of 15.33%.
Obviously, if all there is, all you're looking at is Project A, this is a go.
But now let's look at a second project, Project B.
Try that one more time.
Project B.
Now in Project B, something interesting is going to happen here.
First of all, let me hide this just for a second so you can see something.
Now Project B will have a net present value of $3,734.
The NPV of Project B is below the NPV of Project A,
but the internal rate of return of Project B is higher than the internal rate of return of Project A,
which means that if you take it NPV, you go A.
If you take it internal rate of return, you go Project B, if they're mutually exclusive projects.
So what's a mother to do in a situation like that?
The most popular method is called equivalent lives.
We see that Project C is $25,000 out to begin with, then $12,000 in for year one,
$15,000 for period two, and $6,000 for period three.
It's three years long. Project A is six years long.
So the trick here is to say, what if we do Project B twice?
We overlap Project B so that we have the same number of years that Project B is running that Project A would be running.
So what we would do in this case is we would say, okay, Project B is winding down in year three.
Let's do it again.
Starting, try that again.
Well, I give up.
Starting in year three, we're going to do the very same project.
Do you see how Project B has negative $25,000, $12,000, $15,000, $6,000?
And then in year three, we're going to do it again and realize the same cash flows from year three to year six,
so that the two projects have equivalent lives.
We can do Project A once for six years, or we can do Project B twice for six years.
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.
But then we are going to go back and spend the $25,000 again in year three and run it over again
so that the same cash flows that occurred in years zero through three also occur in years three through six.
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.
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
and the second time you did it.
So for Project B, the new way to look at the cash flow is, okay, year zero, you spend $25,000.
Year one, you get $12,000 in.
Year two, you get the $15,000 in.
But in year three, you get $6,000 minus, you're going to do it over, minus the $25,000.
So the net is you're down in year three to $19,000.
And then in year four, you're just repeating, you're reliving the dream.
$12,000, $15,000, $6,000, just like happened the first time.
So the new profile for the new free cash flow profile from year zero to six is $25,000 down, negative,
then $12,000, then $15,000, and then negative $19,000.
And then you're back up, you've got $12,000, just like you did the first time, $15,000, and $6,000.
And you do the overlap, where do you start the new one?
Wherever it will end so that it has the equivalent years of the Project A.
So if for five years I would have put it up here, just started it up here, put it up here,
if this had been a five-year Project A, had been a five-year Project,
I would have put the repeat of Project B up here, starting here, so that they end at the same time.
That's all you do.
And this spreadsheet that I'm showing you here will do it automatically.
All you have to do is repeat the original free cash flows.
That's all you have to do.
Putting them in the place so that the last one occurs at the same time as the last one in Project A.
And then this column, the year equivalent column, will calculate on its own.
Now you notice something really odd happens.
The NPV looks nasty on it.
Yeah, it does, as a matter of fact.
Boy, that's a nasty negative.
But look at this.
You kind of ignore the internal rate of return because it doesn't mean anything.
As a matter of fact, let me fix that right now.
Ah, better not, better not even try that.
Notice now we have a modified internal rate of return.
And notice now that Project B sucks both NPV and IRR, modified internal rate of return.
The NPV of Project B on a year equivalent basis is negative $18,800.
And the modified internal rate of return, which is what you would look at because of the switch in sign, is only 12.81%.
So that advantage it had in the first pass disappears when you do it on a year equivalent basis.
So Project A is the go project.
The only reason that the internal rate of return of Project B was so good was because it was a quick blast project.
It wasn't a long haul.
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.
It was only good because it was shorter.
But when you look at it in the same time frame as Project A, it's no good.
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,
and then copy those cash flows over so that you've got year equivalents.
You've got the same number of years.
That's all there is.
And then everything else will spit out for you.
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.
Just play with it.
You'll get the hang of it.
Let me save as browse.
I'll just put this in downloads and call it Projects Mutually Exclusive.
And then I'm going to upload it to Canvas so I don't forget to do it.
And of course I went out of Canvas, so here we go again.
Got to go in and do it over again.
Go over to the files, spreadsheets, upload, and look at my downloads.
I put it there.
And there you go.
It's all yours.
Now there's one last part of this story.
And this would not really have been much of an issue 20 years ago.
Certainly, I can't imagine talking much about it back 40 years ago when I was a young teacher.
But here's something.
A lot of companies are facing a rather nasty decision with respect to technological growth, technological improvements.
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.
Or you could go more expensive with computers that are future-proofed and they might last you six years.
Hell, some of the places I've taught, they lasted 10 years.
But it's a real decision.
Do you go cheap and then have to replace them in a few years?
Or do you go expensive and not need to replace them for a much longer time period?
And this is happening especially with computers, but it's also happening in this era of electric vehicles.
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,
just old-fashioned diesel engine, newest versions, those will last seven, eight, 10 years.
Notwithstanding any virtue legislation, I should point out.
But, or I could go with electric vehicles.
Now electric vehicles are definitely going to be improving.
Right now they actually kind of suck.
They have very short haul mileage, especially if they're pulling big loads.
The batteries will improve in efficiency and they will also improve in terms of weight.
And this is going to happen over the next three to five years.
So in other words, if I buy electric vehicles, I will probably really want to replace those within about four years.
Because the ones that are coming online in four years are going to be so much more efficient.
They'll haul much bigger loads and they will have much lower weight on the batteries in them.
Or I can buy just some big old-fashioned diesel trucks and they'll last me for another, they'll go for 10 years.
So the decision has to be like that.
Now there's another way you can do it and they talk about it in the book, show you some examples.
But classically this would be a mutually exclusive thing.
Either you buy the new technology, which you will have to replace in four years,
or you go with an older technology, which will probably be more expensive comparatively speaking,
but it will last you for a longer, much longer time.
And you're seeing that in a lot of different places, even in consumer electronics.
And it's actually almost the perverse of it.
In marketing, did they talk to you about what are called early adopters?
Okay, this is really, really something in mobile phones.
The classic example now being Samsung, which came out three years ago or four years ago
with the first fold and or flip phones.
And the technologies just sucked.
The face of them would crease, it would crack, but, and they were ridiculously expensive.
What we rely on is early adopters, the people who just have to have the newest and best.
Knowing as we do that with technologies like this, two things are going to happen.
One, the design is going to improve from one generation to the next of the phones.
What are we now in?
Generation four of the Samsung, generation five of the Motorola Flips or something like that.
Okay, and then another thing that's going to come online, competition.
There will be producers who will just sit back and let the big dogs tear each other up
and get all kinds of bad reputation for these early technology phones that don't work very well.
And then they'll come in once the technology has improved,
and they will force everyone to drop their prices.
As we're seeing now, especially with Motorola, but even Samsung is doing it now too.
So there is another odd example of what happens.
Technologies that you have to replace very early, within a couple of years,
or technologies that last much longer.
And so we're seeing these kinds, the technological age that we're in now
is bringing up more and more of these mutually exclusive projects,
where even in our daily lives we have to make some kind of an internal,
net present value internal rate of return calculation,
although we probably don't do it formally, we're still thinking about it.
The lesson is, let the early adopters buy the technology,
and then you buy it after it's cheaper and less expensive.
That's all I have for you today, I thank you.