Alan Cring Productions in association with Emergent Light Studio presents the Illinois State Collegiate Compendium, academic lectures in business and economics.
This is business finance, FIL 341 for Autumn Semester 2024.
Today, capital budgeting. This is the last full chapter in the textbook that I will have you do.
And it's a subject that you saw before in FIL 240. I take a little bit of extension to it in this course though.
But essentially capital budgeting is real old school and it is still used to this day.
And it probably will still be in play over the coming couple of decades.
And I don't foresee it changing. However, just as a note, and we'll look at the numbers here in just a minute,
but just as a note, there are new ways coming along.
These are ways that you can't do really with Excel or with pen and paper or financial calculators, these new ways.
They are beginning to get noticed and they are being used but only in very special situations.
When I teach FIL 349, I show a company actually using this,
the company that pioneered the use of a new way for yes or no on projects.
It involves options pricing. So I have to teach some options pricing if you don't take the FIL 347 before I can teach that in 349.
But it is a new way. It is not commonly used and like I said, old fashioned net present value and internal rate of return
and God forbid, really old school payback period method are still the rule of the day.
And so that's where I focus it here. But I do want to bring up this new method that,
I mean it's good, but I mean it is way too advanced for really even a course at the MBA level.
It's almost still PhD level, but you can code it in, I've seen it coded into Python and R,
but I'm not really interested in standing on that hill here in undergrad work at all.
But anyway, let's look at the numbers. And markets are in kind of a chipper mood.
They've kind of leveled off here the last couple of hours and I'll turn down these lights so you can see this a little better.
But they started out really perky and getting very excited about the, to some extent, I mean some analysts are saying,
well this is because of the election, they're all excited because one of the candidates is now projected to win by many of the pollsters.
But I don't see that as being the real driving force. It's more just a normal day on Wall Street.
As you can see, it's classic, Dow is up.88%, S&P up more, 1.02%, and then the NASDAQ up the most.
The interesting thing about it is that as you can see, there was a surge in the morning,
in the early trading for about the first hour, two hours, and then it just sort of leveled off and then there was another surge.
And now there's a little bit of profit taking occurring. It's nothing spectacular.
A little troubling, crude oil came up hard for a while and then it dropped back down.
It was out of that trading range from about 69 to 72. It broke out of that up to the upside,
but then it turned right around, as you can see, and dropped very hard back down.
There's still some of a war premium in there, but it doesn't seem to be causing any long-term secular movement upward in oil prices.
You'd be pretty happy around 71 a barrel right now, but like I said, how long that will last is anyone's guess.
Gold bugs are just bouncing around. There's no reason to pay attention to them right now.
But the bonds, there was a real concern on the part of financial economists like I am that it was a real hard pop.
And you can see that. Now that was very close to the opening bell this morning.
A little before it, there was a big sell-off of bonds and that drove the prices.
A sell-off drives the prices down and the yields up. And that sell-off just was just troubling. What the hell?
And then all of a sudden, it's just died away. After that sell-off, the rest of the day has been buying them back.
And therefore driving the prices up and the yields down. So right now we're only up about one basis point and a half right now.
So that was a little worrisome. What the heck those bond traders, those bond investors were thinking there early in the morning.
I have nothing. I was asking two people who have bond desks, one of them former student of mine,
and they said they didn't see anything that could have been a good reason for that fast sell-off.
But the one who is more experienced said it might have just been some big ass player doing a quick portfolio adjustment,
dumping bonds and moving them over. And he said you see that right there near the opening bell,
stocks were up. That was about the same time that the sell-off in bonds happened.
So it might have just been a sell-off in bonds which drove their prices down and yields up.
And the proceeds of those sales went over to equities. And you can see that little spike there in the equities at the opening bell.
Now remember again, and I emphasize this, that the bonds are trading on a different time schedule.
So you see that that happened after the bond market had been running for a few hours.
And that spike happened when the markets, the equity markets were just starting to wake up.
So they are coordinated and I mean it's just like they just sold off and then they ran right over to equities
and bought up some stocks. And now for the rest of the day there's just been normal activity and a little sell-off
and that has driven some buying back of the bonds so that that would drive the prices up and the yields down
as the overindulgence in equities kind of began to give them indigestion. I don't know.
That's about as good of an explanation as I can get. But when you think about this, you're going into finance.
These are the kinds of thinking patterns that you are going to want to develop.
And I certainly don't expect you, until you get to the really upper, upper level courses, to have this
and you can walk through the economics, the supply and demand dynamics, you can do that on your own very quickly.
Eventually it will come to you. You'll get to the point where you can do this.
But that's kind of what I'm doing now. It's kind of one of the things that you will be able to do as time goes along
as you get more seasoned and experienced, especially if you get into trading and investments.
You'll begin to think in this way yourself. But going over here, what do I look at?
Japan had kind of an odd day. Usually it just pops at the beginning or drops at the beginning.
And this one, it had a slow crawl through the morning in Tokyo and then it just sort of leveled out after that.
Kind of an unusual day. And I don't even pretend to understand Asian markets any more than I understand
how to make a good egg foo young. But London started out in a good mood and then it just went into the toilet
and now it's decided to be in a good mood again. It's just really rollicky over there right now.
But let me get this real quick up here so you can see the VIX. And you'll notice that volatility is something that we care about
because that is a forewarning of movements in stocks themselves. And if we look at the VIX right now,
it's, look at that. Look at that today. It fell off a cliff.
There in the right as trading was happening, volatility calmed down.
I might be able to explain that as, okay, when that surge of money came through into the equities market,
as you can see at the opening bell in the three big numbers, that in itself can actually be a way to call it,
volatility calms down. Instead of the great uncertainty of what's going to happen today,
if you've got that much order power at the beginning, the market makers get their liquidity fixed up within minutes,
if not seconds, and that calms everything down once they've got their liquidity all lined up for the day's trading.
And that may be why that fell off the face of the earth there. It seems to be coming up a little bit now here, right now.
It seems to be coming up a little bit. And of course, about the uncertainty,
if the markets are beginning to see who is going to win the election, then that takes away an uncertainty of volatility right there.
And that seems, I mean, probably of the people I've talked to this morning, maybe 80% of them have said they are sure of who's going to win the election.
And so even if they're wrong, they think it's going to happen, so that in itself is enough to calm everyone down and make the certainty go away.
Now if they're wrong, they're wrong. If they're right, they're right. But right now, it's just that they feel like they've got it.
They know what's going to happen. So there you go. Yes, we can kind of, the consensus can see very darkly a future.
Is that the future that will happen? That's another matter entirely.
But remember, everything in our world is not about the past. It's about our expectations of the future.
So there's nothing unusual about what I talk like this, because it's all about expectations, our markets are.
Let me get down to the meat of this lecture here. I have a spreadsheet for you, and I want to show this to you.
Oh my god. Okay. And one thing I've never done on this one is the old-school method, but let me show you real quick here in your Canvas.
Let's go to 341 here, and we'll do the student view so you can see it the way you'll see it.
Canvas files, spreadsheets. Now this one is called NPV and IRR.XSLX.
This is a calculator for net present values and internal rates of return.
Now, if you were my student in FIOS 240, you're familiar with this.
I have beefed it up a little bit from there and made it a little clearer, but I do want to bring it up to you right now,
just so you're ready for it and we'll have it up for us when we do these kinds of problems.
Okay. Now, this is the NPV IRR main sheet.
And in this sheet, do not worry about the second panel right here, the one with the 12%.
That is there only as a comparator. You don't write numbers down from it in any assessment.
You are just looking at it to see how it compares to what's in the main sheet.
Now, as you can see, this is designed to do a five-year project.
You can insert lines, but you have to adjust the formula for more than five years or fewer than five years.
But five years is the one that I would ask you on a quiz or on the final exam.
Okay, but you can insert a couple of years if you want, but make sure you adjust the formula
so that it looks at all of those instead of just the five that are in the code right now.
But this is a nice, simple to use.
And then I also have the modified internal rate of return method and the crossover analysis and breakeven.
Breakeven is so easy, it's almost not worth doing a spreadsheet,
but hey, if we got a spreadsheet available, we might as well do breakeven on it as well.
And I don't want to trivialize breakeven because we all do it.
I mean, I do it in my business. Even giant companies do simple breakeven analysis.
There's nothing complicated at all about it.
But let me start with the basic, and this may sound like deja vu all over again for some of you,
but let me dig through here and see if I've got a marker. I do.
Okay. Here's the thing. The idea of accepting and rejecting projects is not new.
It is as ancient as humankind. Do we do this or do we walk away and say FTS?
It goes back even to before there were written records.
We have clear evidence of pre-writing societies that engaged in long-term projects
that would have required what in their time was human capital, not dollar capital,
but they were nonetheless, they were an expenditure of opportunity costs on a long-term basis,
which means capital was involved. Human capital, entrepreneurial capital,
all that good stuff, just not with dollars and cents.
In fact, one thing that we do know is that where capital budgeting was not used,
the consequences were actually quite bad.
And that's why once people had seen a non-analytical approach to deciding yes or no on a project,
they saw the consequences of not paying attention to that, they reformed.
Good examples of that were in the ancient dynasties of Egypt.
The pyramids were ridiculously stupid projects, and it finally got to the point where those big,
huge, gorgeous pyramids of Giza, they damaged the economy of ancient Egypt so badly
it was generations before the economy recovered.
Hence why you don't see those ginormous ones other than for those three big behemoths around there.
Once they saw that these were bad ideas economically, they moved to more modest things.
In fact, in some cases, they built their crypts underground.
So there is, obviously there is an understanding, at least over time, that we have to have analytical tools
to be able to decide yes or no to projects.
That is what we call capital budgeting decision making, and that's the subject we're going to talk about now.
Let me take you on a little bit of a journey here that kind of takes, goes off the,
what does this have to do with finance?
But bear with me for a few minutes and you will see why.
When I, and I would start this story around the time of the quote unquote fall of the Roman Empire,
about AD 476.
The Visigoths came in, ransacked the hell out of Rome, tore it to shreds,
executed a bunch of people that were leaders, although they didn't kill the emperor
because he was such a pathetic little twit.
But anyway, and the problem with, one of the big things about that was
that Rome had pumped enlightenment, technologies, knowledge into all of Europe,
west and east, mostly western Europe, and the British Isles.
For centuries it had been doing that.
But when Rome shut down, pretty much, the light that had been Rome just, it just vanished.
And within decades, not centuries, within decades, the, all through Europe and the British Isles,
everyone went back to extraordinarily primitive technologies compared to what they had had during the Roman times.
Agriculture basically went back about a thousand years.
Roads were not really a thing after Rome.
Sewerage systems, water systems, all of that just gone.
Houses went back to fat strews and miserable stuff like that.
Hygiene went away for the most part, all through the Roman lands.
And so we're coming to a point where we have an economy, a macro economy of Europe and the British Isles
that was, had just completely spiraled down.
There weren't any really new inventions in the time.
There were a few, but it was really not any time when you did anything more than live and die.
As they, as this old saying goes, in the dark ages, you lived a short life, you stunk, and then you died miserably.
Okay, good news.
Now I use the term dark ages.
That's not a popular term these days, but it really was a dark time.
Interesting, that was the time of feudalism, an economic system where the land is owned by nobility, by noble, the noble class.
Freeman, who were by and large, who were all free men, freemen.
Okay, good news. We get to an interesting period in this.
And everyone else worked on the lands of these nobles, the lord and the lady of the manor, as it were.
Now everyone else was just miserable, working class.
They call it, use the word serfs, but it was a more appropriate term that you don't need to know, but we use the term villains for them.
They lived on the land intergenerationally.
They worked the farm crops, and they took care of herds of animals.
They gave the lord and the lady a giant chunk of what they created, and then they kept some for themselves.
And this went on over a number of generations.
Something interesting began to happen in the 1200s.
The climate of Western Europe, Great Britain, and in fact this extended into China too, into Asia I should say, it moderated a lot.
The winters were not nearly as harsh, rains followed by sunshine, warmer temperatures, all through Western Europe and Great Britain.
It was an odd period, and with that period we definitely see, and there were censuses taken meticulously in this era.
And the censuses were clearly indicating the productivity was going up.
People felt better, they grew better crops, they ate more, they had, essentially they enjoyed life and they could live a little longer.
And it got so serious that there's one census book that's recording non-freeman owning land, which is just impossible in a pure feudal system.
We have documentation of this, non-nobles who actually have their own giant plots of land.
So there you go, good times.
Well unfortunately that was followed in the 1300s by a mini ice age. Everything turned to hell.
And you went downhill very quickly in the economies of Western Europe, Great Britain, and all that, and even into Asia.
And I think it was, we've got some reasons to believe that it happened in North Africa too.
Okay, what that meant was that the feudalism took a nasty turn. We have seen this all through history.
That the same odd thing that happens when times get bad, especially when climate change gets very serious on a fairly rapid basis,
you get what's called an enclosure movement.
Now an enclosure movement, like I said, we've seen them documented in civilizations all through history.
Here's how it works. The nobility simply says to the people, the Vellains, the Serfs, what have you, get off the land. Go away.
You may come back for the planting and the harvest, but otherwise leave.
Of course this was horrible because the vast majority of these people had lived there intergenerationally.
Their families, their villages, everything.
And matter of fact they had lived there so long that we saw the rise of Surnames at water.
Well these are the Vellains who live at the water and all those kinds of things.
It was that deep, the roots of the people in the land, and then the noble said, get off.
We'll kill you if you don't leave. Then they burned their villages, burned their houses, ransacked everything that was worth anything,
and left all of these people on the roads.
Now here's what happens when you're on the roads.
Rumors begin to start. We've seen it all through history.
In fact, after the Dust Bowl and the Great Depression, you had the Okies, as they were called,
and all the other people here on the prairie on the roads, and they started the rumors.
Well I hear that California is a place of land, milk, and honey.
And we're going out there because there are jobs out there. We're all going out to California.
That was the thing, but it happens in every enclosure or diaspora, as it were, movement.
You can see the diaspora as the Hebrews.
They were booked and got out of Egyptian territory.
They had a sense that there was some place that was so good, the land of manna, the milk and honey.
We see it all through history.
So these people, and I'm going to focus on Great Britain now,
they all started heading for where they heard the jobs were plentiful and everything was good.
The big cities, London, Kent, places like that.
So you have all of these miserably poor people starving, heading towards the big cities.
They went down those roads.
They took their ships along the sides of the roads. They pissed on the sides of the roads.
They had their babies along the sides of the old roadways, muddy as they were and miserable.
They died when they crawled under a bridge so that they wouldn't bother anyone with their death.
It was awful.
But what was even more awful was as they were heading down the roads,
behind them were following the rats.
And on the rats were the fleas and on the fleas were the plagues.
The first aspect of the plagues was the pneumonic plague.
It caused essentially a pneumonia.
And that killed off the very old and the children and the immune compromised.
But it also weakened the strong.
And that gave a foothold for the next phase, the bubonic plague.
And as they came in on the cities, they compressed.
The people per square foot, as it were, got thicker and thicker, denser and denser,
as you came towards the city centers.
And that just spread the diseases like wildfire.
It wasn't just pneumonic and bubonic.
It was King Cholera, as they come to call it in England and others.
And there was an even worse thing.
They could not burn the bodies because that was against church law to burn.
And there weren't enough able-bodied people to bury all of those,
so you had an environmental catastrophe.
By the time the plague was over in about 10 to 15 years,
a quarter to a third of all of Western Europe and Great Britain was dead.
That is ungodly. That's an un-staggering amount.
Okay, you had a complete, a total decrop of population,
including the strong as well as the children.
Well, there's something interesting that happens when something like that occurs.
The people who were survivors, they came to say something along the lines of FTS.
Oh, you want, oh, you Mr. Nobleman want me to make brick house for you?
Well, screw you. If you're going to pay me a lot, I'll do it.
You see, the labor supply had collapsed.
And so you had the rise of powerful guilds and middle class.
And they were sick of what had happened.
They did not want to look back to the past.
Those old, even the old tunics that were this miserable dark indigo,
then people walked around in those and they wore a hat so the lights wouldn't pop around on their heads.
They started saying, I'm going to tie this up.
I want to let it, I want to feel my form in this.
Oh, look at this. I'm wearing a dress. Let me sew these up on the sides.
I'm pants. I got pants, everybody.
All that started to happen.
And they were looking for a way forward, new stuff.
Anything that was new, anything that was different.
This was when you started getting translations into the Vulgate of the Bible, even.
And of course, the church executed the first ones who did this.
Later, they started stealing their books, their translations.
But here's the thing.
That opened up opportunities.
And here we're getting back to business now.
One thing, oh, we can, these people want spices and things like that.
Well, we usually go east toward China.
Oh, that's a bad thing to do because you're going to go a long way.
It's going to take months and months.
And you're going to face weather.
You're going to face all the vandals and highwaymen all along the way.
So a couple of them began to think, maybe we should go that way to get around that way.
Yes, everyone knew the world was round.
It was a sphere.
They didn't account for the fact that there was this giant, big landmass between Europe and China.
Well, that's a story I'll get to in a minute here.
But they also saw there were some, they wanted to see where they could find stuff.
And a couple of very adventuresome explorers headed toward Rome.
Now, very few people had even thought about going back down there because of the mountains, the ice,
the miserable dangers along the way, again, of vandals, highwaymen, and other uncouth sorts.
But a couple did.
And when they came back, they had something fascinating to tell.
People said, oh, you went down there.
You saw all the ruins.
I'll bet there's no one there.
Oh, no.
Rome is alive again.
Yeah.
And you should see it.
It is so different from what we think.
And they started describing paintings that don't look like stick figures praying to God with a halo around their head.
No, they're drawing art that looks like real people.
And there's these sculptors that are drawing naked humans not ashamed of themselves with muscles bulging and sinews stringing out.
It's gorgeous.
And their literature isn't about going to heaven or going to hell.
It's about human needs, happiness, sadness, love, sex.
All those are now in their literature down there.
And everyone yelled, more, more of that.
And so the age of exploration begins to form.
Now, this is where we get a little bit more into capital budgeting.
You see, because you hear about all Christopher Columbus, he appealed to Queen Isabella of Spain.
That's where they got the money.
No, they didn't.
They were going everywhere.
And they were going to private, rich families and rich people.
They were going anywhere they could.
As a matter of fact, Christopher Columbus, actually, a full one of his ships,
remember he sailed the Niña de Santa Maria and the Pinta.
Those weren't their actual names.
Those are more invented modern names.
But in fact, his brother, Christopher Columbus's brother, went to a rich guy and said, look, we need ships.
And this guy said, OK, but I am going to, I'll build it.
But I am going to be the commander of that ship.
You do not get to touch that ship.
In other words, he was going to be an investor, but he was going to watch his investment like a hawk all the way there and all the way back.
And when they came back, they brought back all these incredible things, tomatoes, corn, slaves, for God's sake.
And this, everyone just said, more, more.
We want this.
This is what we want.
So in other words, they could command money, actual money, for what they did.
In other words, there was free cash flow.
There was upfront capital investment, year zero, and then there was money to flow after that from the sale of the goods that they found and the services in the case of the slaves.
So there was the first round of it.
Now reel this and take us to another part of Europe that sounds like it has nothing to do with this, to Italy, to a monastery in the middle of nowhere and a monk by the name of Patioli.
Patioli was a monk.
He had, if I remember right, he had a permanent lifetime vow of silence.
Now when you're a monk and you can't even yell out, hey everybody, you get bored.
And what did he do?
He did something that you do to this day.
He invented an accounting system.
Well, there had been an accounting system before this, but this one was something special.
You may recognize the term.
He called it a double ledger accounting system.
You remember debits and credits, that horrible stuff that you did?
That is Patioli's invention.
And matter of fact, back in my time, there was one of the first computer programs that did accounting was called the Patioli system.
But anyway, okay, so that meant that investors could say we want projections, financial projections, in a specific system so we can compare different people who are asking for our capital.
And we can compare them in a sense, apples to apples.
You all follow the Patioli system and you will be able, we'll look at them and see what we want to invest in and what we don't want to invest in.
So we begin to get into a systematized way of presenting the data for capital budgeting.
And it goes from there.
As it began to take hold, you had a need, okay, we've got a project.
Then the next part is, okay, we've got a capital budgeting framework.
How much is needed, what the free cash flow is going to be.
Okay, how would we use this to make a decision, yes or no?
The first system, and believe it or not, it's still used to this day.
In my consulting, it kind of blew me away when I saw this being used, but it is still used.
There was a survey a few years back by a business, a polling company.
What method do you use for capital budgeting decision making?
Now there are three methods.
One of them, the ancient method, payback period.
Definitely the one that was being used from the literature that we see, we've got a lot of literature from the 1500s, 1600s.
Definitely it was being used then, it's still being used in some companies to this day.
The other two methods, the more modern scientific methods, are net present value and internal rate of return.
These are scientific mathematical methods.
But that survey, they found out that it was something like 15 to 20% of companies still use payback period, centuries after it was developed.
This is one of the things that happens.
What you are engaged in now is bringing the best practices modern methods out into the corporations.
So that as time goes on, you as you rise in your influence in the corporations can bring with you in that rise what you learned here.
And then bring that into the full use of companies.
But in some companies they are still using payback period.
It's really simple and it kind of, it makes sense, but it just doesn't have a scientific basis.
And I'll explain it here in a minute.
But anyway, now interestingly enough, net present value and internal rate of return are definitely being used the most.
The odd thing is that the one of those two that's the most popular is actually the weaker of the two.
Internal rate of return is the one that is most popular and it is the weakest, it is the weaker of the two.
For a couple of reasons it's the weaker of the two.
But it's still the most popular.
And in a way it actually does make sense, but if you use it for the wrong free cash flow stream, you get answers that mean nothing.
And there are a surprising number of companies that I've run into.
They have no idea that you can't just use it on any free cash flow projections that you get.
You just can't use it.
Now there is a modification of internal rate of return called MIRR that corrects for one of its major flaws, but there's still another major flaw in it.
And I'll explain that in a bit.
Let me get over here, payback period.
Let me take a free cash flow.
Year free cash flow, FCF.
Now year zero, let's say that you're going to need $50,000 in capital.
So you've got a negative on that year zero.
This is a simplified case, and I'll get to more complex cases where you need money at first, you make some money, then you need more money.
That's where internal rate of return falls down, but I'll get to that later.
But let's say now in year one you get some revenue, $10,000 as you're ramping up the operations.
Year two you come up here to $20,000.
Year three you come up to $30,000.
And year four you're beginning to tail back out.
And then in year five when the project ends, you put in counting your last sales of inventory and your salvage value, which I'll bring up very much in a while.
You end up with $5,000.
Okay, so good things going on here.
We've got some projections, and this is where the issue of we've got the data, how do we use it comes in.
The payback period method says any project that we take on must pay for itself within a certain number of years.
Let's say that this company has a payback period of three years.
Okay, let's go through it here.
You're down $50,000 starting out.
Now you're going to come up, and so after the first year you're down, you've got, you've pulled in $10,000, so you're still down $40,000 on your initial investment.
Now a year later with $20,000 more coming in, you're now down only $20,000.
One year out and you're up $10,000, and then another year into it you're up $35,000, and at the end you have come up a total from your initial investment, positive $40,000.
So if the payback period is three years and three years were positive, it's a go.
That's all there is to it.
You see its simplicity and why originally in the 1500s, 1600s it would have been obviously, well yeah, this is exactly right, this is great.
Still used to this day though in companies.
I mean I had several consulting jobs where they were, the one, it was a, they call it disruptive technology, but it was essentially a new form of battery that was malleable.
It could be shaped around something.
It could be cut apart.
It was kind of a cool technology.
Never went anywhere though.
But he said, well, he just blankly said three years is what we have for our payback period.
Now real forward to a company that was, this was a large company.
I mean had its total assets was in the $2 to $3 billion range, something like that.
They invited me to dinner one night and I was just sitting there talking with a few people and I heard the head of treasury talking about this equipment that they were,
that an operations manager had asked for them to purchase.
And the head of treasury was saying, well it's obvious, you know, we're going to spend $850,000 and it's going to pull no more than maybe $500,000 in the first four years, five years.
She said you obviously reject it.
That, she was thinking payback period.
I mean she didn't say payback period, but you could tell she was just counting the number of years before it would finally cover the cost of the investment.
So it's still being used even if not officially, it's still being used in a thinking way.
Now the first problem with the payback period method, the first problem is that it doesn't take in the present value of these numbers.
These numbers here are not comparable to this unless you discount them back to the current time.
$25,000 in four years is not $25,000 compared to negative $50,000.
You have to take the present value of it to see what its now value is.
That is, now that can be corrected with what's called the discounted payback period method.
You just take the present values of those.
Okay, we're over that hurdle.
The big 800 pound gorilla is this right here.
Where do you get the three years?
Well, you pull it out of your ass.
I've asked companies, well why in one, why six years?
Well, that's what we've always done.
I mean six years, that sounds reasonable.
Reasonable sounds reasonable is not what we do in business these days.
We need a reason, a numbers reason.
And just saying, well this is the way we've always done it, that's fine with us.
You try to tell them about net present value method, internal rate of return method,
and they say, well it might be right for some, but it ain't for us.
God-fearing folks, I'll tell you that right now.
My daddy used it this way, and that's the way we're going to use it too in the business.
Okay, does that mean that it's full of crap?
Well, the reality is from what we can tell from some research that we've done,
companies that use the payback period method,
for the most part actually choose successful projects.
And the question is, well, why?
How could that be happening?
I'm kind of on the side, having been a real-life consultant,
that it's because they have a sense internally, someone is a good business person,
you know them, they pick winners.
They wouldn't even have considered a project that something in their brain,
their somewhat unusual brain, would have said, no, don't even look at that.
They're predisposing the possibilities to those that would be winners.
And so the payback period method is really, what they're doing is they're seeing how long,
somewhere in their thinking they're seeing how long those successful projects usually took
to make the money back from them.
And so it's not completely irrational at all.
But you have to have that kind of mind to know how many years good projects take
to pay off the initial investment.
That's probably a lot of what's going on, why the payback period method does have some success,
and it is an enduring phenomenon after centuries of use.
But it's not the best way.
Now, here's the next part of it.
We go to the net present value and the internal rate of return methods.
Now, there are a couple of things to talk about along the way.
That last year, there were a couple of things, pitfalls in free cash flow analysis, in projecting.
The one that is the killer, and we see it over and over again, is too much optimism about,
first of all, whether a project will be successful or not.
Well, I can't tell you how many times I heard something that wasn't exactly like this.
This product is going to sell like hotcakes.
We're going to sell them off the shelf the first week we put them out there.
Everyone's going to want this. Everyone.
And that's overly optimistic.
So obviously, you have to temper in making the pro formas your enthusiasm
and your idealizations of projects.
And I'll talk about this more on Thursday.
And some spectacular failures based upon not looking at everything.
And if there's anything that I hope you can do out there is not fall into group think,
where everyone in the meeting room gets on board with some great idea that is just incredible.
We're going to do this. Does everyone agree?
Yay, we're going to do this.
And there's a little voice inside you that says, oh, this is bad.
But you don't say anything.
So the project goes forward.
Anyone think of a good example of that?
I won't mention any names, but Bud is a good example of that.
And there are other ones too where they don't let you don't even let yourself say, hold up here.
Let's get back to the numbers and see if these are realistic or not.
So you always have to watch out for that.
And also in the negative $50,000, you include everything in that original amount.
And that means you include opportunity cost, which is the great killer when companies,
government agencies, they don't think about anything but what they have to buy to get the project underway.
Now, years ago, I was teaching at another university right nearby here before I got a great offer here.
Not a great offer, but the students are a lot more interesting here.
But they said there was a project that was under consideration in Bloomington.
And it was a big hot thing at the time.
We're going to build a sports arena.
Now, this was one of those things that's like a legacy project.
The mayor knew that her time was short as mayor.
So she wanted something that would be her shrine when she was when she retired,
sort of like the shrine of our current president with that College of Engineering boondoggle.
I didn't say that. I'm going to have to really delete that. Seriously.
But OK, well, she brought in her finance manager.
The business professors were supposed to bring all of their students to this presentation
she was going to make one evening, one early evening, about how great this project was.
So she brought along her finance guy, a little weasel of a guy.
She had him on a leash. Come, come. Talk to them about the finance of this. Good boy.
And so he gets up there, he shows all the pro forma, the projections, and right off the bat,
I mean, I was hoping during the question and answer, some of the students would raise their hands
and ask pointed questions, but they were just interested in getting out of there
and going and getting baked and laid. So they didn't ask any questions.
But the question, I didn't say that either. But look, here's the first thing.
She said, OK, this arena is going, this is Bloomington right here.
See this? This is Bloomington. Who am I kidding? This is Bloomington right here.
OK? And our universe of people who will buy tickets to the venues is 60 miles.
Everyone who's going 60 miles is going to buy tickets to watch concerts, to see shows.
Well, first of all, what's within 60 miles? I'll tell you, there are two things.
The Civic, Peoria Civic Center is within 60 miles, and the rest of that 60 miles is corn and soybeans.
You're not going to get farmer, yeah, well, let's go watch the death metal tonight.
See, they're having a real good concert at the convention arena in Bloomington.
No, they're not going to. That was the first assumption.
You're not going to have that big a consumer market, so you're not going to sell that many tickets.
But then the next thing came along. The city manager was going through the financials.
He was going through it really fast so that he could get out of there and go home.
But he got to the part about showing all the different costs, and he said, OK, are there any questions about this?
And I raised my hand. I said, where is the cost of the land?
And he, without thinking, he said, oh, we already own the land.
And I just tapped my hand down. I said, you already own the land.
So in other words, it's not a direct cost. It's an opportunity cost. You know that. You learned that.
He was graduated from there. He knew that that land was not free.
It was, you could have sold that land. You could have leased that land. So it is a cost of this project.
And there were a lot of other opportunity costs. So don't miss the opportunity costs.
You got a new project. Oh, we're just going to use one of our existing managers, and we're going to put him on this project.
So he has an opportunity cost in this project because he is not in that project where he was anymore.
You see, opportunity costs are the great killer that you don't think about if you aren't trained in finance.
And you are. So don't let that slip by you. Look at all the things that were used that look free, but they are not free.
Now along the way, there are all kinds of things that you can do. A lot of companies, when they do projections,
they just do them like the book did in that chapter, just the growth rate of the or some models.
There's a lot of software. You could just key in the parameters and it will give you projections of revenue.
And then remember for the revenues, you can, you get percentages of all the other numbers in the income statement and the balance sheets the same way.
Okay, we're all good on that. But I want to bitch at you down here. But first of all, revenues.
Incremental revenues. In other words, you sandbox the project.
You do not consider this project in the context of the company itself because it's not part of the company.
It is in its own world. So in other words, you don't say, well, this will boost sales over here.
So we can add a little bit to the revenues because it will increase revenues of this and that.
Don't do that unless you have really good reasons to do that. Now there are sometimes good reasons to do that.
But initially, only the increment of this product or service on its own should be included.
So now let me put where there are exceptions. Sometimes products have synergies with other products.
Sometimes they have synergies. In other words, they really will help the revenues of another product in your life.
As a matter of fact, a number of companies these days, they deliberately aim to create products that synergize with some of their existing line.
Companies that make printers, Canon, Hewlett Packard, Brother, they will provide the printers at very low cost.
Revenues suck. But where they make their money is off the toner cartridges and all of that good stuff that go with the printers.
So they are synergizing from the printers to existing product lines. The same thing happens in other venues.
I had to get a nice little blood glucose meter. It still hurts like hell, that lancet.
Well, it was almost free. It was like $9.99. And oh, they're going to make their money because they've got a lifetime sucker to buy their lancets.
Oh, you can't use any lancets but ours in this meter. And the test strips. Oh, you can't use any other test strips but ours in the meter.
And the diet plans and the lifestyle adjustments. Screw that. I'm not going to live my life like that. I'll eat a piece of cake, damn it.
But that's all part of it. You see, they are synergizing off something that has very low revenue, but it creates higher revenues for things around.
So yeah, synergies do exist. Don't start by assuming it unless you really intend for it to happen.
The other thing is that companies avoid like the plague is the downside where you have cannibalism.
Cannibalism. You do not want to make a product that eats into the revenues of another product.
And companies will tear their butts to keep that from happening.
In fact, car companies, when they build new cars, they make sure that they are not cannibalizing revenues off the cars that are already in their brand.
Great examples are, well Toyota is a wonderful example, Nissan.
They build, and this has been going on for years, they build a very small, very inexpensive starter car.
Now they know that that's not going to be the car that these people use in a few years.
So what they do is over time they will upgrade that starter car. It has the same name but it's nicer and nicer.
So that you sir will not always be a miserable, starving student.
You will rise indeed to high levels. And what they want to do is, as long as they can, provide you with that car that you loved so much,
but now it is more appropriate for you and your new life. All the way up.
The cars, classic, for example, Toyota. Great example is their RAV4.
It started out as this cute little mini SUV, barely fit four people, relatively inexpensive,
but now you look at one of those things going down the road and you wonder if there's a truck coming beside you.
Because that person who bought it as a 20 year old, 22 year old, at an affordable price, now has four kids and a couple of dogs and all that.
So they build, now the RAV4s are a much better car.
And underneath them they've designed cars that are now the ones for the new 20 year olds.
In other words, they follow demographic waves as we say.
So they want to make sure that no car cannibalizes another car.
So the luxury line of Nissans up there at the level of, I'm trying to think, what would be the Sentra, it's not the luxury.
But they have a completely different line of cars with a different name, no apparent connection that they have for the wealthiest.
So that you can follow the track up the straight Nissan line or you can follow and suddenly jump over to an Infiniti and you don't know that it's the same manufacturer.
All those things are part of the whole problem of cannibalism.
We want to avoid it whenever we can.
Companies will make the same product with different looks to them to sell to different target markets.
Because they don't want those products to cannibalize each other.
So they'll make it completely different for a completely different market.
So that's cannibalism.
Watch out for it.
Now, on cost, the big thing is costs.
Now, incrementalism, just the cost of this project.
However, the one thing that you can include, volume discounts.
If you've got a new product that uses some of the same inputs as an existing product, you can get sometimes a supplier to give you a discount.
We used to order 80,000 units.
Now we're going to order 110,000.
Come on, give us a little bit of a bone here.
Give us a discount.
We're ordering more.
And that will work.
So volume discounts can cause a synergistic effect on other products and what you pay for those products in larger volumes of discount.
So yeah, that's there too.
But also, don't forget the cost can turn the other way.
As a company grows, its operations get more complex.
And it is something about complexity itself that makes your daggone costs rise nonlinearly.
When I started going to several different products, it got more costly than it was just for the extra product.
And I still don't know why.
But it does get more costly sometimes.
So yeah, just be careful about reducing costs when you say, well, this product, this new product will have a good effect on cost from another product.
Now, the last thing here, salvage value.
Unfortunately, your book doesn't pay nearly enough attention to it.
And it is an 800-pound gorilla.
At the end of the project.
Now, salvage value you will add to the last year of free cash flow.
Again, salvage value you add to the last year of free cash flow.
So in other words, if your free cash flow is 2000 and your salvage value is 3000, then that last year won't be 2000.
It will be 2000 plus 3000, 5000.
Don't get confused by that in a problem I give you.
Here's the thing.
Salvage value can be positive or negative.
Salvage value, whether you use it or not, you have to include it.
Companies have equipment at the end of the life of a project.
A lot of companies just drive it to a field and let it die there.
That's what they do.
The factories.
There's a great example out there on GE Road.
If you ever pass the Walgreens, it's on the other side of the Walgreens.
There's a ginormous friggin' factory out there.
It's been dead for years.
And it's still on the books.
The salvage value, they could have sold it right after they decommissioned it out there, but they didn't.
They just let it sit.
So they did not include in their analysis that money that would have come in from that project.
Here in this building, some years ago, there was a room, and it's still part of it's there.
They're opening it up.
But it was a ghastly room.
I know it was always locked, but there was this one time when they wanted me,
when I was still doing a lot of portrait photography and all that,
they wanted me to take photographs of all the people, the administrative people and the faculty.
For a really nice portfolio.
And so I said, well, I'll have to get set up and get a place for us to do this and get all my lighting.
They said, oh no, we've got a room where you can go.
And they took me and they said, is this good enough?
And it was like a cavern.
But all along the walls were these things.
They were old computers, monitors.
I mean, I'm talking about those giant computers that had disk drives.
And they had dial-up modem equipment, phone systems with the wires and the end of the wall.
They had all of that in this room, all over the place.
When they replaced computers with upgrades, they took the old ones down there.
They could have sold those.
Or hell, they could have given them to schools around the underprivileged schools.
The kids would have died to have a computer that was three years out of date or two years out of date.
But they just put the stuff downstairs there.
And so there was an example again of salvage value unrealized.
It happens all the time.
And you have to set out a roadmap at the beginning for what you will do with the equipment when you decommission.
It's just part of what you do.
Now, that's positive salvage value.
Here's the dark side of salvage value, the negatives.
And this is the one that until recently it had been completely ignored.
And then it came back to bite these companies in the ass.
If they had considered it upfront and made arrangements to deal with it at the back end,
they would not have had such catastrophes happen.
Does anyone know the biggest negative salvage value?
Anyone got a stab at it?
Environmental remediation.
When you close down, you would not believe environmental remediation affects almost every project you will undertake.
And if you ignore it and you just bury the crap out there and you just walk away,
lolling your way into the future, suddenly about 10, 15 years later,
you can get a class action lawsuit of a billion dollars from people who are starting to get cancer
because your crap leached into the water supply.
It's all over the place.
And it's not just toxic chemicals.
Things like electronics are environmental catastrophes waiting to happen.
You can't just bury them.
And there are all kinds of other things.
USTs, which are underground storage tanks.
We find them all the time.
Companies twinkle-toed away, sold the land, and then later we find a UST under there.
And so the company that has gone away, forgot all about what it did,
it gets sued back to the Stone Age for misrepresenting the state of the property upon sale.
So this is a major issue.
And figuring out what to do with it at the beginning will give the people who are there at the end of the life of the project,
they will bless you.
Maybe things will change, but at least you will have given them a roadmap out of hell for this.
Another one is what's called tailing liability.
Products that after you close down the project, they can hurt people afterwards.
They can cause all kinds of danger.
Now, if you had included those costs when you first found NPV IRR,
you might have even rejected the project because it would have had such a fat-ass negative salvage value there on the end.
Excellent example of that was private airplanes.
I used to be a private pilot, and you flew Cessnas, the beaches, the Pipers,
well, there were some Pipers out there.
But here was the interesting thing.
Years after those planes were built, they had a funny habit of breaking apart in the sky.
Now, that's a bad thing.
I mean, I'll tell you right now, having a plane with a wing come off really makes you sad
when you're at about 3,000 feet.
When I was first learning how to fly, the instructor said,
tell me about your fears.
I don't know, why are you a psychotherapist?
I said, I'm afraid the plane is going, the engine's going to quit.
And he said, oh, don't worry about that.
Really? Yeah, we'll make it to the crash site.
Really? Yeah.
So anyway, yeah, these planes started breaking in the air, the struts on those high wings.
And then all of a sudden you got this wing saying hi at you and all that.
And so they started getting lawsuits that drove them into bankruptcy.
If they had thought upfront, you buy tail liability insurance.
You say, okay, this is going to be a cost upfront.
We get the quotes for this.
Yeah, it's a lot of money.
But if you don't do it, you're probably going to pay a hell of a lot more.
It will come back to haunt you.
That positive NPV project turns out to be a negative NPV project.
Well, that tells you something, Cupcake.
We don't do this project.
Instead of, well, let's just ignore it and then it's okay.
I would, you know, some of you know that I used to run a paranormal society,
ghost hunting club here on campus.
Okay, you can either look at the building and you can say this is haunted AF.
Or you can go in there and then you have to deal with someone in the crowd
getting demonically possessed and then you've got a real problem.
I have to go down and get them from hell and I've got meetings.
I can't do that for a couple of weeks and then they're all bitching at me.
That's all I have for you today.
I thank you.