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Alan Cring Productions in association with Emergent Light Studio presents the Illinois State Collegiate Compendium, academic lectures in business and economics.

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This is business finance, FIL 341 for Autumn Semester 2024.

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Today, capital budgeting. This is the last full chapter in the textbook that I will have you do.

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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.

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But essentially capital budgeting is real old school and it is still used to this day.

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And it probably will still be in play over the coming couple of decades.

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And I don't foresee it changing. However, just as a note, and we'll look at the numbers here in just a minute,

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but just as a note, there are new ways coming along.

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These are ways that you can't do really with Excel or with pen and paper or financial calculators, these new ways.

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They are beginning to get noticed and they are being used but only in very special situations.

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When I teach FIL 349, I show a company actually using this,

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the company that pioneered the use of a new way for yes or no on projects.

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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.

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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

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and God forbid, really old school payback period method are still the rule of the day.

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And so that's where I focus it here. But I do want to bring up this new method that,

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I mean it's good, but I mean it is way too advanced for really even a course at the MBA level.

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It's almost still PhD level, but you can code it in, I've seen it coded into Python and R,

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but I'm not really interested in standing on that hill here in undergrad work at all.

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But anyway, let's look at the numbers. And markets are in kind of a chipper mood.

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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.

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But they started out really perky and getting very excited about the, to some extent, I mean some analysts are saying,

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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.

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But I don't see that as being the real driving force. It's more just a normal day on Wall Street.

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As you can see, it's classic, Dow is up.88%, S&P up more, 1.02%, and then the NASDAQ up the most.

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The interesting thing about it is that as you can see, there was a surge in the morning,

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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.

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And now there's a little bit of profit taking occurring. It's nothing spectacular.

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A little troubling, crude oil came up hard for a while and then it dropped back down.

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It was out of that trading range from about 69 to 72. It broke out of that up to the upside,

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but then it turned right around, as you can see, and dropped very hard back down.

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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.

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You'd be pretty happy around 71 a barrel right now, but like I said, how long that will last is anyone's guess.

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Gold bugs are just bouncing around. There's no reason to pay attention to them right now.

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But the bonds, there was a real concern on the part of financial economists like I am that it was a real hard pop.

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And you can see that. Now that was very close to the opening bell this morning.

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A little before it, there was a big sell-off of bonds and that drove the prices.

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A sell-off drives the prices down and the yields up. And that sell-off just was just troubling. What the hell?

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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.

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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.

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So that was a little worrisome. What the heck those bond traders, those bond investors were thinking there early in the morning.

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I have nothing. I was asking two people who have bond desks, one of them former student of mine,

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and they said they didn't see anything that could have been a good reason for that fast sell-off.

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But the one who is more experienced said it might have just been some big ass player doing a quick portfolio adjustment,

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dumping bonds and moving them over. And he said you see that right there near the opening bell,

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stocks were up. That was about the same time that the sell-off in bonds happened.

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So it might have just been a sell-off in bonds which drove their prices down and yields up.

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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.

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Now remember again, and I emphasize this, that the bonds are trading on a different time schedule.

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So you see that that happened after the bond market had been running for a few hours.

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And that spike happened when the markets, the equity markets were just starting to wake up.

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So they are coordinated and I mean it's just like they just sold off and then they ran right over to equities

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and bought up some stocks. And now for the rest of the day there's just been normal activity and a little sell-off

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and that has driven some buying back of the bonds so that that would drive the prices up and the yields down

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as the overindulgence in equities kind of began to give them indigestion. I don't know.

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That's about as good of an explanation as I can get. But when you think about this, you're going into finance.

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These are the kinds of thinking patterns that you are going to want to develop.

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And I certainly don't expect you, until you get to the really upper, upper level courses, to have this

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and you can walk through the economics, the supply and demand dynamics, you can do that on your own very quickly.

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Eventually it will come to you. You'll get to the point where you can do this.

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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

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as you get more seasoned and experienced, especially if you get into trading and investments.

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You'll begin to think in this way yourself. But going over here, what do I look at?

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Japan had kind of an odd day. Usually it just pops at the beginning or drops at the beginning.

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And this one, it had a slow crawl through the morning in Tokyo and then it just sort of leveled out after that.

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Kind of an unusual day. And I don't even pretend to understand Asian markets any more than I understand

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how to make a good egg foo young. But London started out in a good mood and then it just went into the toilet

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and now it's decided to be in a good mood again. It's just really rollicky over there right now.

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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

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because that is a forewarning of movements in stocks themselves. And if we look at the VIX right now,

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it's, look at that. Look at that today. It fell off a cliff.

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There in the right as trading was happening, volatility calmed down.

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I might be able to explain that as, okay, when that surge of money came through into the equities market,

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as you can see at the opening bell in the three big numbers, that in itself can actually be a way to call it,

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volatility calms down. Instead of the great uncertainty of what's going to happen today,

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if you've got that much order power at the beginning, the market makers get their liquidity fixed up within minutes,

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if not seconds, and that calms everything down once they've got their liquidity all lined up for the day's trading.

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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.

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It seems to be coming up a little bit. And of course, about the uncertainty,

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if the markets are beginning to see who is going to win the election, then that takes away an uncertainty of volatility right there.

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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.

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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.

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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.

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They know what's going to happen. So there you go. Yes, we can kind of, the consensus can see very darkly a future.

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Is that the future that will happen? That's another matter entirely.

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But remember, everything in our world is not about the past. It's about our expectations of the future.

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So there's nothing unusual about what I talk like this, because it's all about expectations, our markets are.

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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.

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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.

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Let's go to 341 here, and we'll do the student view so you can see it the way you'll see it.

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Canvas files, spreadsheets. Now this one is called NPV and IRR.XSLX.

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This is a calculator for net present values and internal rates of return.

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Now, if you were my student in FIOS 240, you're familiar with this.

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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,

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just so you're ready for it and we'll have it up for us when we do these kinds of problems.

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Okay. Now, this is the NPV IRR main sheet.

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And in this sheet, do not worry about the second panel right here, the one with the 12%.

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That is there only as a comparator. You don't write numbers down from it in any assessment.

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You are just looking at it to see how it compares to what's in the main sheet.

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Now, as you can see, this is designed to do a five-year project.

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You can insert lines, but you have to adjust the formula for more than five years or fewer than five years.

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But five years is the one that I would ask you on a quiz or on the final exam.

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Okay, but you can insert a couple of years if you want, but make sure you adjust the formula

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so that it looks at all of those instead of just the five that are in the code right now.

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But this is a nice, simple to use.

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And then I also have the modified internal rate of return method and the crossover analysis and breakeven.

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Breakeven is so easy, it's almost not worth doing a spreadsheet,

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but hey, if we got a spreadsheet available, we might as well do breakeven on it as well.

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And I don't want to trivialize breakeven because we all do it.

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I mean, I do it in my business. Even giant companies do simple breakeven analysis.

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There's nothing complicated at all about it.

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But let me start with the basic, and this may sound like deja vu all over again for some of you,

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but let me dig through here and see if I've got a marker. I do.

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Okay. Here's the thing. The idea of accepting and rejecting projects is not new.

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It is as ancient as humankind. Do we do this or do we walk away and say FTS?

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It goes back even to before there were written records.

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We have clear evidence of pre-writing societies that engaged in long-term projects

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that would have required what in their time was human capital, not dollar capital,

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but they were nonetheless, they were an expenditure of opportunity costs on a long-term basis,

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which means capital was involved. Human capital, entrepreneurial capital,

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all that good stuff, just not with dollars and cents.

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In fact, one thing that we do know is that where capital budgeting was not used,

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the consequences were actually quite bad.

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And that's why once people had seen a non-analytical approach to deciding yes or no on a project,

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they saw the consequences of not paying attention to that, they reformed.

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Good examples of that were in the ancient dynasties of Egypt.

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The pyramids were ridiculously stupid projects, and it finally got to the point where those big,

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huge, gorgeous pyramids of Giza, they damaged the economy of ancient Egypt so badly

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it was generations before the economy recovered.

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Hence why you don't see those ginormous ones other than for those three big behemoths around there.

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Once they saw that these were bad ideas economically, they moved to more modest things.

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In fact, in some cases, they built their crypts underground.

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So there is, obviously there is an understanding, at least over time, that we have to have analytical tools

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to be able to decide yes or no to projects.

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That is what we call capital budgeting decision making, and that's the subject we're going to talk about now.

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Let me take you on a little bit of a journey here that kind of takes, goes off the,

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what does this have to do with finance?

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But bear with me for a few minutes and you will see why.

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When I, and I would start this story around the time of the quote unquote fall of the Roman Empire,

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about AD 476.

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The Visigoths came in, ransacked the hell out of Rome, tore it to shreds,

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executed a bunch of people that were leaders, although they didn't kill the emperor

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because he was such a pathetic little twit.

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But anyway, and the problem with, one of the big things about that was

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that Rome had pumped enlightenment, technologies, knowledge into all of Europe,

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west and east, mostly western Europe, and the British Isles.

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For centuries it had been doing that.

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But when Rome shut down, pretty much, the light that had been Rome just, it just vanished.

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And within decades, not centuries, within decades, the, all through Europe and the British Isles,

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everyone went back to extraordinarily primitive technologies compared to what they had had during the Roman times.

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Agriculture basically went back about a thousand years.

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Roads were not really a thing after Rome.

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Sewerage systems, water systems, all of that just gone.

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Houses went back to fat strews and miserable stuff like that.

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Hygiene went away for the most part, all through the Roman lands.

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And so we're coming to a point where we have an economy, a macro economy of Europe and the British Isles

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that was, had just completely spiraled down.

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There weren't any really new inventions in the time.

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There were a few, but it was really not any time when you did anything more than live and die.

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As they, as this old saying goes, in the dark ages, you lived a short life, you stunk, and then you died miserably.

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Okay, good news.

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Now I use the term dark ages.

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That's not a popular term these days, but it really was a dark time.

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Interesting, that was the time of feudalism, an economic system where the land is owned by nobility, by noble, the noble class.

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Freeman, who were by and large, who were all free men, freemen.

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Okay, good news. We get to an interesting period in this.

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And everyone else worked on the lands of these nobles, the lord and the lady of the manor, as it were.

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Now everyone else was just miserable, working class.

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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.

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They lived on the land intergenerationally.

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They worked the farm crops, and they took care of herds of animals.

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They gave the lord and the lady a giant chunk of what they created, and then they kept some for themselves.

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And this went on over a number of generations.

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Something interesting began to happen in the 1200s.

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The climate of Western Europe, Great Britain, and in fact this extended into China too, into Asia I should say, it moderated a lot.

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The winters were not nearly as harsh, rains followed by sunshine, warmer temperatures, all through Western Europe and Great Britain.

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It was an odd period, and with that period we definitely see, and there were censuses taken meticulously in this era.

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And the censuses were clearly indicating the productivity was going up.

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People felt better, they grew better crops, they ate more, they had, essentially they enjoyed life and they could live a little longer.

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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.

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We have documentation of this, non-nobles who actually have their own giant plots of land.

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So there you go, good times.

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Well unfortunately that was followed in the 1300s by a mini ice age. Everything turned to hell.

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And you went downhill very quickly in the economies of Western Europe, Great Britain, and all that, and even into Asia.

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And I think it was, we've got some reasons to believe that it happened in North Africa too.

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Okay, what that meant was that the feudalism took a nasty turn. We have seen this all through history.

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That the same odd thing that happens when times get bad, especially when climate change gets very serious on a fairly rapid basis,

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you get what's called an enclosure movement.

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Now an enclosure movement, like I said, we've seen them documented in civilizations all through history.

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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.

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You may come back for the planting and the harvest, but otherwise leave.

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Of course this was horrible because the vast majority of these people had lived there intergenerationally.

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Their families, their villages, everything.

194
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And matter of fact they had lived there so long that we saw the rise of Surnames at water.

195
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Well these are the Vellains who live at the water and all those kinds of things.

196
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It was that deep, the roots of the people in the land, and then the noble said, get off.

197
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We'll kill you if you don't leave. Then they burned their villages, burned their houses, ransacked everything that was worth anything,

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and left all of these people on the roads.

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Now here's what happens when you're on the roads.

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Rumors begin to start. We've seen it all through history.

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In fact, after the Dust Bowl and the Great Depression, you had the Okies, as they were called,

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and all the other people here on the prairie on the roads, and they started the rumors.

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Well I hear that California is a place of land, milk, and honey.

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And we're going out there because there are jobs out there. We're all going out to California.

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That was the thing, but it happens in every enclosure or diaspora, as it were, movement.

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You can see the diaspora as the Hebrews.

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They were booked and got out of Egyptian territory.

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They had a sense that there was some place that was so good, the land of manna, the milk and honey.

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We see it all through history.

210
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So these people, and I'm going to focus on Great Britain now,

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they all started heading for where they heard the jobs were plentiful and everything was good.

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The big cities, London, Kent, places like that.

213
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So you have all of these miserably poor people starving, heading towards the big cities.

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They went down those roads.

215
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They took their ships along the sides of the roads. They pissed on the sides of the roads.

216
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They had their babies along the sides of the old roadways, muddy as they were and miserable.

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They died when they crawled under a bridge so that they wouldn't bother anyone with their death.

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It was awful.

219
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But what was even more awful was as they were heading down the roads,

220
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behind them were following the rats.

221
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And on the rats were the fleas and on the fleas were the plagues.

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The first aspect of the plagues was the pneumonic plague.

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It caused essentially a pneumonia.

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And that killed off the very old and the children and the immune compromised.

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But it also weakened the strong.

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And that gave a foothold for the next phase, the bubonic plague.

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And as they came in on the cities, they compressed.

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The people per square foot, as it were, got thicker and thicker, denser and denser,

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as you came towards the city centers.

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And that just spread the diseases like wildfire.

231
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It wasn't just pneumonic and bubonic.

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It was King Cholera, as they come to call it in England and others.

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And there was an even worse thing.

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They could not burn the bodies because that was against church law to burn.

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And there weren't enough able-bodied people to bury all of those,

236
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so you had an environmental catastrophe.

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By the time the plague was over in about 10 to 15 years,

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a quarter to a third of all of Western Europe and Great Britain was dead.

239
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That is ungodly. That's an un-staggering amount.

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Okay, you had a complete, a total decrop of population,

241
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including the strong as well as the children.

242
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Well, there's something interesting that happens when something like that occurs.

243
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The people who were survivors, they came to say something along the lines of FTS.

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Oh, you want, oh, you Mr. Nobleman want me to make brick house for you?

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Well, screw you. If you're going to pay me a lot, I'll do it.

246
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You see, the labor supply had collapsed.

247
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And so you had the rise of powerful guilds and middle class.

248
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And they were sick of what had happened.

249
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They did not want to look back to the past.

250
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Those old, even the old tunics that were this miserable dark indigo,

251
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then people walked around in those and they wore a hat so the lights wouldn't pop around on their heads.

252
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They started saying, I'm going to tie this up.

253
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I want to let it, I want to feel my form in this.

254
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Oh, look at this. I'm wearing a dress. Let me sew these up on the sides.

255
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I'm pants. I got pants, everybody.

256
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All that started to happen.

257
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And they were looking for a way forward, new stuff.

258
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Anything that was new, anything that was different.

259
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This was when you started getting translations into the Vulgate of the Bible, even.

260
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And of course, the church executed the first ones who did this.

261
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Later, they started stealing their books, their translations.

262
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But here's the thing.

263
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That opened up opportunities.

264
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And here we're getting back to business now.

265
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One thing, oh, we can, these people want spices and things like that.

266
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Well, we usually go east toward China.

267
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Oh, that's a bad thing to do because you're going to go a long way.

268
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It's going to take months and months.

269
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And you're going to face weather.

270
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You're going to face all the vandals and highwaymen all along the way.

271
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So a couple of them began to think, maybe we should go that way to get around that way.

272
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Yes, everyone knew the world was round.

273
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It was a sphere.

274
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They didn't account for the fact that there was this giant, big landmass between Europe and China.

275
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Well, that's a story I'll get to in a minute here.

276
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But they also saw there were some, they wanted to see where they could find stuff.

277
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And a couple of very adventuresome explorers headed toward Rome.

278
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Now, very few people had even thought about going back down there because of the mountains, the ice,

279
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the miserable dangers along the way, again, of vandals, highwaymen, and other uncouth sorts.

280
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But a couple did.

281
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And when they came back, they had something fascinating to tell.

282
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People said, oh, you went down there.

283
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You saw all the ruins.

284
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I'll bet there's no one there.

285
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Oh, no.

286
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Rome is alive again.

287
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Yeah.

288
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And you should see it.

289
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It is so different from what we think.

290
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And they started describing paintings that don't look like stick figures praying to God with a halo around their head.

291
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No, they're drawing art that looks like real people.

292
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And there's these sculptors that are drawing naked humans not ashamed of themselves with muscles bulging and sinews stringing out.

293
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It's gorgeous.

294
00:31:19,000 --> 00:31:23,000
And their literature isn't about going to heaven or going to hell.

295
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It's about human needs, happiness, sadness, love, sex.

296
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All those are now in their literature down there.

297
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And everyone yelled, more, more of that.

298
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And so the age of exploration begins to form.

299
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Now, this is where we get a little bit more into capital budgeting.

300
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You see, because you hear about all Christopher Columbus, he appealed to Queen Isabella of Spain.

301
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That's where they got the money.

302
00:31:56,000 --> 00:31:57,000
No, they didn't.

303
00:31:57,000 --> 00:31:58,000
They were going everywhere.

304
00:31:58,000 --> 00:32:04,000
And they were going to private, rich families and rich people.

305
00:32:04,000 --> 00:32:05,000
They were going anywhere they could.

306
00:32:05,000 --> 00:32:12,000
As a matter of fact, Christopher Columbus, actually, a full one of his ships,

307
00:32:12,000 --> 00:32:18,000
remember he sailed the Niña de Santa Maria and the Pinta.

308
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Those weren't their actual names.

309
00:32:19,000 --> 00:32:22,000
Those are more invented modern names.

310
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But in fact, his brother, Christopher Columbus's brother, went to a rich guy and said, look, we need ships.

311
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And this guy said, OK, but I am going to, I'll build it.

312
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But I am going to be the commander of that ship.

313
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You do not get to touch that ship.

314
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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.

315
00:32:50,000 --> 00:33:00,000
And when they came back, they brought back all these incredible things, tomatoes, corn, slaves, for God's sake.

316
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And this, everyone just said, more, more.

317
00:33:03,000 --> 00:33:04,000
We want this.

318
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This is what we want.

319
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So in other words, they could command money, actual money, for what they did.

320
00:33:11,000 --> 00:33:14,000
In other words, there was free cash flow.

321
00:33:14,000 --> 00:33:26,000
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.

322
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So there was the first round of it.

323
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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.

324
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Patioli was a monk.

325
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He had, if I remember right, he had a permanent lifetime vow of silence.

326
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Now when you're a monk and you can't even yell out, hey everybody, you get bored.

327
00:33:59,000 --> 00:34:01,000
And what did he do?

328
00:34:01,000 --> 00:34:05,000
He did something that you do to this day.

329
00:34:05,000 --> 00:34:09,000
He invented an accounting system.

330
00:34:09,000 --> 00:34:14,000
Well, there had been an accounting system before this, but this one was something special.

331
00:34:14,000 --> 00:34:16,000
You may recognize the term.

332
00:34:16,000 --> 00:34:20,000
He called it a double ledger accounting system.

333
00:34:20,000 --> 00:34:23,000
You remember debits and credits, that horrible stuff that you did?

334
00:34:23,000 --> 00:34:26,000
That is Patioli's invention.

335
00:34:26,000 --> 00:34:35,000
And matter of fact, back in my time, there was one of the first computer programs that did accounting was called the Patioli system.

336
00:34:35,000 --> 00:34:52,000
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.

337
00:34:52,000 --> 00:34:56,000
And we can compare them in a sense, apples to apples.

338
00:34:56,000 --> 00:35:03,000
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.

339
00:35:03,000 --> 00:35:12,000
So we begin to get into a systematized way of presenting the data for capital budgeting.

340
00:35:12,000 --> 00:35:15,000
And it goes from there.

341
00:35:15,000 --> 00:35:23,000
As it began to take hold, you had a need, okay, we've got a project.

342
00:35:23,000 --> 00:35:29,000
Then the next part is, okay, we've got a capital budgeting framework.

343
00:35:29,000 --> 00:35:33,000
How much is needed, what the free cash flow is going to be.

344
00:35:33,000 --> 00:35:39,000
Okay, how would we use this to make a decision, yes or no?

345
00:35:39,000 --> 00:35:45,000
The first system, and believe it or not, it's still used to this day.

346
00:35:45,000 --> 00:35:51,000
In my consulting, it kind of blew me away when I saw this being used, but it is still used.

347
00:35:51,000 --> 00:35:57,000
There was a survey a few years back by a business, a polling company.

348
00:35:57,000 --> 00:36:01,000
What method do you use for capital budgeting decision making?

349
00:36:01,000 --> 00:36:03,000
Now there are three methods.

350
00:36:03,000 --> 00:36:09,000
One of them, the ancient method, payback period.

351
00:36:09,000 --> 00:36:17,000
Definitely the one that was being used from the literature that we see, we've got a lot of literature from the 1500s, 1600s.

352
00:36:17,000 --> 00:36:22,000
Definitely it was being used then, it's still being used in some companies to this day.

353
00:36:22,000 --> 00:36:46,000
The other two methods, the more modern scientific methods, are net present value and internal rate of return.

354
00:36:46,000 --> 00:36:51,000
These are scientific mathematical methods.

355
00:36:51,000 --> 00:37:04,000
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.

356
00:37:04,000 --> 00:37:06,000
This is one of the things that happens.

357
00:37:06,000 --> 00:37:14,000
What you are engaged in now is bringing the best practices modern methods out into the corporations.

358
00:37:14,000 --> 00:37:24,000
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.

359
00:37:24,000 --> 00:37:29,000
And then bring that into the full use of companies.

360
00:37:29,000 --> 00:37:33,000
But in some companies they are still using payback period.

361
00:37:33,000 --> 00:37:42,000
It's really simple and it kind of, it makes sense, but it just doesn't have a scientific basis.

362
00:37:42,000 --> 00:37:44,000
And I'll explain it here in a minute.

363
00:37:44,000 --> 00:37:52,000
But anyway, now interestingly enough, net present value and internal rate of return are definitely being used the most.

364
00:37:52,000 --> 00:37:59,000
The odd thing is that the one of those two that's the most popular is actually the weaker of the two.

365
00:37:59,000 --> 00:38:07,000
Internal rate of return is the one that is most popular and it is the weakest, it is the weaker of the two.

366
00:38:07,000 --> 00:38:12,000
For a couple of reasons it's the weaker of the two.

367
00:38:12,000 --> 00:38:16,000
But it's still the most popular.

368
00:38:16,000 --> 00:38:27,000
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.

369
00:38:27,000 --> 00:38:31,000
And there are a surprising number of companies that I've run into.

370
00:38:31,000 --> 00:38:38,000
They have no idea that you can't just use it on any free cash flow projections that you get.

371
00:38:38,000 --> 00:38:40,000
You just can't use it.

372
00:38:40,000 --> 00:38:50,000
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.

373
00:38:50,000 --> 00:38:56,000
And I'll explain that in a bit.

374
00:38:56,000 --> 00:39:02,000
Let me get over here, payback period.

375
00:39:02,000 --> 00:39:04,000
Let me take a free cash flow.

376
00:39:04,000 --> 00:39:11,000
Year free cash flow, FCF.

377
00:39:11,000 --> 00:39:19,000
Now year zero, let's say that you're going to need $50,000 in capital.

378
00:39:19,000 --> 00:39:22,000
So you've got a negative on that year zero.

379
00:39:22,000 --> 00:39:30,000
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.

380
00:39:30,000 --> 00:39:34,000
That's where internal rate of return falls down, but I'll get to that later.

381
00:39:34,000 --> 00:39:41,000
But let's say now in year one you get some revenue, $10,000 as you're ramping up the operations.

382
00:39:41,000 --> 00:39:45,000
Year two you come up here to $20,000.

383
00:39:45,000 --> 00:39:51,000
Year three you come up to $30,000.

384
00:39:51,000 --> 00:39:57,000
And year four you're beginning to tail back out.

385
00:39:57,000 --> 00:40:11,000
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.

386
00:40:11,000 --> 00:40:13,000
You end up with $5,000.

387
00:40:13,000 --> 00:40:17,000
Okay, so good things going on here.

388
00:40:17,000 --> 00:40:26,000
We've got some projections, and this is where the issue of we've got the data, how do we use it comes in.

389
00:40:26,000 --> 00:40:38,000
The payback period method says any project that we take on must pay for itself within a certain number of years.

390
00:40:38,000 --> 00:40:49,000
Let's say that this company has a payback period of three years.

391
00:40:49,000 --> 00:40:51,000
Okay, let's go through it here.

392
00:40:51,000 --> 00:40:54,000
You're down $50,000 starting out.

393
00:40:54,000 --> 00:41:05,000
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.

394
00:41:05,000 --> 00:41:14,000
Now a year later with $20,000 more coming in, you're now down only $20,000.

395
00:41:14,000 --> 00:41:37,000
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.

396
00:41:37,000 --> 00:41:44,000
So if the payback period is three years and three years were positive, it's a go.

397
00:41:44,000 --> 00:41:46,000
That's all there is to it.

398
00:41:46,000 --> 00:41:57,000
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.

399
00:41:57,000 --> 00:42:01,000
Still used to this day though in companies.

400
00:42:01,000 --> 00:42:17,000
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.

401
00:42:17,000 --> 00:42:21,000
It could be shaped around something.

402
00:42:21,000 --> 00:42:23,000
It could be cut apart.

403
00:42:23,000 --> 00:42:25,000
It was kind of a cool technology.

404
00:42:25,000 --> 00:42:27,000
Never went anywhere though.

405
00:42:27,000 --> 00:42:37,000
But he said, well, he just blankly said three years is what we have for our payback period.

406
00:42:37,000 --> 00:42:44,000
Now real forward to a company that was, this was a large company.

407
00:42:44,000 --> 00:42:52,000
I mean had its total assets was in the $2 to $3 billion range, something like that.

408
00:42:52,000 --> 00:43:04,000
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,

409
00:43:04,000 --> 00:43:08,000
that an operations manager had asked for them to purchase.

410
00:43:08,000 --> 00:43:23,000
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.

411
00:43:23,000 --> 00:43:25,000
She said you obviously reject it.

412
00:43:25,000 --> 00:43:28,000
That, she was thinking payback period.

413
00:43:28,000 --> 00:43:36,000
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.

414
00:43:36,000 --> 00:43:42,000
So it's still being used even if not officially, it's still being used in a thinking way.

415
00:43:42,000 --> 00:43:52,000
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.

416
00:43:52,000 --> 00:43:59,000
These numbers here are not comparable to this unless you discount them back to the current time.

417
00:43:59,000 --> 00:44:07,000
$25,000 in four years is not $25,000 compared to negative $50,000.

418
00:44:07,000 --> 00:44:12,000
You have to take the present value of it to see what its now value is.

419
00:44:12,000 --> 00:44:17,000
That is, now that can be corrected with what's called the discounted payback period method.

420
00:44:17,000 --> 00:44:19,000
You just take the present values of those.

421
00:44:19,000 --> 00:44:21,000
Okay, we're over that hurdle.

422
00:44:21,000 --> 00:44:25,000
The big 800 pound gorilla is this right here.

423
00:44:25,000 --> 00:44:28,000
Where do you get the three years?

424
00:44:28,000 --> 00:44:31,000
Well, you pull it out of your ass.

425
00:44:31,000 --> 00:44:36,000
I've asked companies, well why in one, why six years?

426
00:44:36,000 --> 00:44:38,000
Well, that's what we've always done.

427
00:44:38,000 --> 00:44:40,000
I mean six years, that sounds reasonable.

428
00:44:40,000 --> 00:44:46,000
Reasonable sounds reasonable is not what we do in business these days.

429
00:44:46,000 --> 00:44:50,000
We need a reason, a numbers reason.

430
00:44:50,000 --> 00:44:56,000
And just saying, well this is the way we've always done it, that's fine with us.

431
00:44:56,000 --> 00:44:59,000
You try to tell them about net present value method, internal rate of return method,

432
00:44:59,000 --> 00:45:01,000
and they say, well it might be right for some, but it ain't for us.

433
00:45:01,000 --> 00:45:04,000
God-fearing folks, I'll tell you that right now.

434
00:45:04,000 --> 00:45:09,000
My daddy used it this way, and that's the way we're going to use it too in the business.

435
00:45:09,000 --> 00:45:13,000
Okay, does that mean that it's full of crap?

436
00:45:13,000 --> 00:45:17,000
Well, the reality is from what we can tell from some research that we've done,

437
00:45:17,000 --> 00:45:21,000
companies that use the payback period method,

438
00:45:21,000 --> 00:45:27,000
for the most part actually choose successful projects.

439
00:45:27,000 --> 00:45:30,000
And the question is, well, why?

440
00:45:30,000 --> 00:45:34,000
How could that be happening?

441
00:45:34,000 --> 00:45:39,000
I'm kind of on the side, having been a real-life consultant,

442
00:45:39,000 --> 00:45:46,000
that it's because they have a sense internally, someone is a good business person,

443
00:45:46,000 --> 00:45:50,000
you know them, they pick winners.

444
00:45:50,000 --> 00:45:55,000
They wouldn't even have considered a project that something in their brain,

445
00:45:55,000 --> 00:46:00,000
their somewhat unusual brain, would have said, no, don't even look at that.

446
00:46:00,000 --> 00:46:09,000
They're predisposing the possibilities to those that would be winners.

447
00:46:09,000 --> 00:46:16,000
And so the payback period method is really, what they're doing is they're seeing how long,

448
00:46:16,000 --> 00:46:22,000
somewhere in their thinking they're seeing how long those successful projects usually took

449
00:46:22,000 --> 00:46:25,000
to make the money back from them.

450
00:46:25,000 --> 00:46:28,000
And so it's not completely irrational at all.

451
00:46:28,000 --> 00:46:35,000
But you have to have that kind of mind to know how many years good projects take

452
00:46:35,000 --> 00:46:39,000
to pay off the initial investment.

453
00:46:39,000 --> 00:46:45,000
That's probably a lot of what's going on, why the payback period method does have some success,

454
00:46:45,000 --> 00:46:51,000
and it is an enduring phenomenon after centuries of use.

455
00:46:51,000 --> 00:46:54,000
But it's not the best way.

456
00:46:54,000 --> 00:46:57,000
Now, here's the next part of it.

457
00:46:57,000 --> 00:47:02,000
We go to the net present value and the internal rate of return methods.

458
00:47:02,000 --> 00:47:09,000
Now, there are a couple of things to talk about along the way.

459
00:47:09,000 --> 00:47:18,000
That last year, there were a couple of things, pitfalls in free cash flow analysis, in projecting.

460
00:47:18,000 --> 00:47:27,000
The one that is the killer, and we see it over and over again, is too much optimism about,

461
00:47:27,000 --> 00:47:32,000
first of all, whether a project will be successful or not.

462
00:47:32,000 --> 00:47:37,000
Well, I can't tell you how many times I heard something that wasn't exactly like this.

463
00:47:37,000 --> 00:47:39,000
This product is going to sell like hotcakes.

464
00:47:39,000 --> 00:47:42,000
We're going to sell them off the shelf the first week we put them out there.

465
00:47:42,000 --> 00:47:44,000
Everyone's going to want this. Everyone.

466
00:47:44,000 --> 00:47:47,000
And that's overly optimistic.

467
00:47:47,000 --> 00:47:54,000
So obviously, you have to temper in making the pro formas your enthusiasm

468
00:47:54,000 --> 00:47:59,000
and your idealizations of projects.

469
00:47:59,000 --> 00:48:02,000
And I'll talk about this more on Thursday.

470
00:48:02,000 --> 00:48:08,000
And some spectacular failures based upon not looking at everything.

471
00:48:08,000 --> 00:48:13,000
And if there's anything that I hope you can do out there is not fall into group think,

472
00:48:13,000 --> 00:48:20,000
where everyone in the meeting room gets on board with some great idea that is just incredible.

473
00:48:20,000 --> 00:48:22,000
We're going to do this. Does everyone agree?

474
00:48:22,000 --> 00:48:24,000
Yay, we're going to do this.

475
00:48:24,000 --> 00:48:29,000
And there's a little voice inside you that says, oh, this is bad.

476
00:48:29,000 --> 00:48:31,000
But you don't say anything.

477
00:48:31,000 --> 00:48:33,000
So the project goes forward.

478
00:48:33,000 --> 00:48:35,000
Anyone think of a good example of that?

479
00:48:35,000 --> 00:48:39,000
I won't mention any names, but Bud is a good example of that.

480
00:48:39,000 --> 00:48:47,000
And there are other ones too where they don't let you don't even let yourself say, hold up here.

481
00:48:47,000 --> 00:48:52,000
Let's get back to the numbers and see if these are realistic or not.

482
00:48:52,000 --> 00:48:54,000
So you always have to watch out for that.

483
00:48:54,000 --> 00:49:03,000
And also in the negative $50,000, you include everything in that original amount.

484
00:49:03,000 --> 00:49:12,000
And that means you include opportunity cost, which is the great killer when companies,

485
00:49:12,000 --> 00:49:21,000
government agencies, they don't think about anything but what they have to buy to get the project underway.

486
00:49:21,000 --> 00:49:30,000
Now, years ago, I was teaching at another university right nearby here before I got a great offer here.

487
00:49:30,000 --> 00:49:34,000
Not a great offer, but the students are a lot more interesting here.

488
00:49:34,000 --> 00:49:43,000
But they said there was a project that was under consideration in Bloomington.

489
00:49:43,000 --> 00:49:45,000
And it was a big hot thing at the time.

490
00:49:45,000 --> 00:49:49,000
We're going to build a sports arena.

491
00:49:49,000 --> 00:49:52,000
Now, this was one of those things that's like a legacy project.

492
00:49:52,000 --> 00:49:56,000
The mayor knew that her time was short as mayor.

493
00:49:56,000 --> 00:50:02,000
So she wanted something that would be her shrine when she was when she retired,

494
00:50:02,000 --> 00:50:07,000
sort of like the shrine of our current president with that College of Engineering boondoggle.

495
00:50:07,000 --> 00:50:11,000
I didn't say that. I'm going to have to really delete that. Seriously.

496
00:50:11,000 --> 00:50:16,000
But OK, well, she brought in her finance manager.

497
00:50:16,000 --> 00:50:22,000
The business professors were supposed to bring all of their students to this presentation

498
00:50:22,000 --> 00:50:29,000
she was going to make one evening, one early evening, about how great this project was.

499
00:50:29,000 --> 00:50:37,000
So she brought along her finance guy, a little weasel of a guy.

500
00:50:37,000 --> 00:50:41,000
She had him on a leash. Come, come. Talk to them about the finance of this. Good boy.

501
00:50:41,000 --> 00:50:47,000
And so he gets up there, he shows all the pro forma, the projections, and right off the bat,

502
00:50:47,000 --> 00:50:54,000
I mean, I was hoping during the question and answer, some of the students would raise their hands

503
00:50:54,000 --> 00:50:58,000
and ask pointed questions, but they were just interested in getting out of there

504
00:50:58,000 --> 00:51:03,000
and going and getting baked and laid. So they didn't ask any questions.

505
00:51:03,000 --> 00:51:08,000
But the question, I didn't say that either. But look, here's the first thing.

506
00:51:08,000 --> 00:51:13,000
She said, OK, this arena is going, this is Bloomington right here.

507
00:51:13,000 --> 00:51:18,000
See this? This is Bloomington. Who am I kidding? This is Bloomington right here.

508
00:51:18,000 --> 00:51:27,000
OK? And our universe of people who will buy tickets to the venues is 60 miles.

509
00:51:27,000 --> 00:51:33,000
Everyone who's going 60 miles is going to buy tickets to watch concerts, to see shows.

510
00:51:33,000 --> 00:51:37,000
Well, first of all, what's within 60 miles? I'll tell you, there are two things.

511
00:51:37,000 --> 00:51:46,000
The Civic, Peoria Civic Center is within 60 miles, and the rest of that 60 miles is corn and soybeans.

512
00:51:46,000 --> 00:51:50,000
You're not going to get farmer, yeah, well, let's go watch the death metal tonight.

513
00:51:50,000 --> 00:51:55,000
See, they're having a real good concert at the convention arena in Bloomington.

514
00:51:55,000 --> 00:51:59,000
No, they're not going to. That was the first assumption.

515
00:51:59,000 --> 00:52:04,000
You're not going to have that big a consumer market, so you're not going to sell that many tickets.

516
00:52:04,000 --> 00:52:09,000
But then the next thing came along. The city manager was going through the financials.

517
00:52:09,000 --> 00:52:14,000
He was going through it really fast so that he could get out of there and go home.

518
00:52:14,000 --> 00:52:22,000
But he got to the part about showing all the different costs, and he said, OK, are there any questions about this?

519
00:52:22,000 --> 00:52:26,000
And I raised my hand. I said, where is the cost of the land?

520
00:52:26,000 --> 00:52:31,000
And he, without thinking, he said, oh, we already own the land.

521
00:52:31,000 --> 00:52:36,000
And I just tapped my hand down. I said, you already own the land.

522
00:52:36,000 --> 00:52:42,000
So in other words, it's not a direct cost. It's an opportunity cost. You know that. You learned that.

523
00:52:42,000 --> 00:52:48,000
He was graduated from there. He knew that that land was not free.

524
00:52:48,000 --> 00:52:54,000
It was, you could have sold that land. You could have leased that land. So it is a cost of this project.

525
00:52:54,000 --> 00:52:59,000
And there were a lot of other opportunity costs. So don't miss the opportunity costs.

526
00:52:59,000 --> 00:53:04,000
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.

527
00:53:04,000 --> 00:53:12,000
So he has an opportunity cost in this project because he is not in that project where he was anymore.

528
00:53:12,000 --> 00:53:19,000
You see, opportunity costs are the great killer that you don't think about if you aren't trained in finance.

529
00:53:19,000 --> 00:53:28,000
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.

530
00:53:28,000 --> 00:53:34,000
Now along the way, there are all kinds of things that you can do. A lot of companies, when they do projections,

531
00:53:34,000 --> 00:53:42,000
they just do them like the book did in that chapter, just the growth rate of the or some models.

532
00:53:42,000 --> 00:53:47,000
There's a lot of software. You could just key in the parameters and it will give you projections of revenue.

533
00:53:47,000 --> 00:53:56,000
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.

534
00:53:56,000 --> 00:54:06,000
Okay, we're all good on that. But I want to bitch at you down here. But first of all, revenues.

535
00:54:06,000 --> 00:54:19,000
Incremental revenues. In other words, you sandbox the project.

536
00:54:19,000 --> 00:54:28,000
You do not consider this project in the context of the company itself because it's not part of the company.

537
00:54:28,000 --> 00:54:35,000
It is in its own world. So in other words, you don't say, well, this will boost sales over here.

538
00:54:35,000 --> 00:54:40,000
So we can add a little bit to the revenues because it will increase revenues of this and that.

539
00:54:40,000 --> 00:54:48,000
Don't do that unless you have really good reasons to do that. Now there are sometimes good reasons to do that.

540
00:54:48,000 --> 00:54:57,000
But initially, only the increment of this product or service on its own should be included.

541
00:54:57,000 --> 00:55:08,000
So now let me put where there are exceptions. Sometimes products have synergies with other products.

542
00:55:08,000 --> 00:55:15,000
Sometimes they have synergies. In other words, they really will help the revenues of another product in your life.

543
00:55:15,000 --> 00:55:25,000
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.

544
00:55:25,000 --> 00:55:33,000
Companies that make printers, Canon, Hewlett Packard, Brother, they will provide the printers at very low cost.

545
00:55:33,000 --> 00:55:41,000
Revenues suck. But where they make their money is off the toner cartridges and all of that good stuff that go with the printers.

546
00:55:41,000 --> 00:55:49,000
So they are synergizing from the printers to existing product lines. The same thing happens in other venues.

547
00:55:49,000 --> 00:55:56,000
I had to get a nice little blood glucose meter. It still hurts like hell, that lancet.

548
00:55:56,000 --> 00:56:07,000
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.

549
00:56:07,000 --> 00:56:14,000
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.

550
00:56:14,000 --> 00:56:21,000
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.

551
00:56:21,000 --> 00:56:30,000
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.

552
00:56:30,000 --> 00:56:37,000
So yeah, synergies do exist. Don't start by assuming it unless you really intend for it to happen.

553
00:56:37,000 --> 00:56:47,000
The other thing is that companies avoid like the plague is the downside where you have cannibalism.

554
00:56:47,000 --> 00:56:58,000
Cannibalism. You do not want to make a product that eats into the revenues of another product.

555
00:56:58,000 --> 00:57:04,000
And companies will tear their butts to keep that from happening.

556
00:57:04,000 --> 00:57:19,000
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.

557
00:57:19,000 --> 00:57:24,000
Great examples are, well Toyota is a wonderful example, Nissan.

558
00:57:24,000 --> 00:57:33,000
They build, and this has been going on for years, they build a very small, very inexpensive starter car.

559
00:57:33,000 --> 00:57:41,000
Now they know that that's not going to be the car that these people use in a few years.

560
00:57:41,000 --> 00:57:49,000
So what they do is over time they will upgrade that starter car. It has the same name but it's nicer and nicer.

561
00:57:49,000 --> 00:57:54,000
So that you sir will not always be a miserable, starving student.

562
00:57:54,000 --> 00:58:03,000
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,

563
00:58:03,000 --> 00:58:09,000
but now it is more appropriate for you and your new life. All the way up.

564
00:58:09,000 --> 00:58:15,000
The cars, classic, for example, Toyota. Great example is their RAV4.

565
00:58:15,000 --> 00:58:25,000
It started out as this cute little mini SUV, barely fit four people, relatively inexpensive,

566
00:58:25,000 --> 00:58:30,000
but now you look at one of those things going down the road and you wonder if there's a truck coming beside you.

567
00:58:30,000 --> 00:58:43,000
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.

568
00:58:43,000 --> 00:58:47,000
So they build, now the RAV4s are a much better car.

569
00:58:47,000 --> 00:58:54,000
And underneath them they've designed cars that are now the ones for the new 20 year olds.

570
00:58:54,000 --> 00:58:58,000
In other words, they follow demographic waves as we say.

571
00:58:58,000 --> 00:59:03,000
So they want to make sure that no car cannibalizes another car.

572
00:59:03,000 --> 00:59:14,000
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.

573
00:59:14,000 --> 00:59:23,000
But they have a completely different line of cars with a different name, no apparent connection that they have for the wealthiest.

574
00:59:23,000 --> 00:59:36,000
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.

575
00:59:36,000 --> 00:59:39,000
All those things are part of the whole problem of cannibalism.

576
00:59:39,000 --> 00:59:41,000
We want to avoid it whenever we can.

577
00:59:41,000 --> 00:59:48,000
Companies will make the same product with different looks to them to sell to different target markets.

578
00:59:48,000 --> 00:59:51,000
Because they don't want those products to cannibalize each other.

579
00:59:51,000 --> 00:59:55,000
So they'll make it completely different for a completely different market.

580
00:59:55,000 --> 00:59:57,000
So that's cannibalism.

581
00:59:57,000 --> 00:59:58,000
Watch out for it.

582
00:59:58,000 --> 01:00:05,000
Now, on cost, the big thing is costs.

583
01:00:05,000 --> 01:00:09,000
Now, incrementalism, just the cost of this project.

584
01:00:09,000 --> 01:00:18,000
However, the one thing that you can include, volume discounts.

585
01:00:18,000 --> 01:00:30,000
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.

586
01:00:30,000 --> 01:00:32,000
We used to order 80,000 units.

587
01:00:32,000 --> 01:00:34,000
Now we're going to order 110,000.

588
01:00:34,000 --> 01:00:36,000
Come on, give us a little bit of a bone here.

589
01:00:36,000 --> 01:00:37,000
Give us a discount.

590
01:00:37,000 --> 01:00:39,000
We're ordering more.

591
01:00:39,000 --> 01:00:40,000
And that will work.

592
01:00:40,000 --> 01:00:54,000
So volume discounts can cause a synergistic effect on other products and what you pay for those products in larger volumes of discount.

593
01:00:54,000 --> 01:00:57,000
So yeah, that's there too.

594
01:00:57,000 --> 01:01:01,000
But also, don't forget the cost can turn the other way.

595
01:01:01,000 --> 01:01:05,000
As a company grows, its operations get more complex.

596
01:01:05,000 --> 01:01:13,000
And it is something about complexity itself that makes your daggone costs rise nonlinearly.

597
01:01:13,000 --> 01:01:20,000
When I started going to several different products, it got more costly than it was just for the extra product.

598
01:01:20,000 --> 01:01:22,000
And I still don't know why.

599
01:01:22,000 --> 01:01:25,000
But it does get more costly sometimes.

600
01:01:25,000 --> 01:01:36,000
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.

601
01:01:36,000 --> 01:01:45,000
Now, the last thing here, salvage value.

602
01:01:45,000 --> 01:01:49,000
Unfortunately, your book doesn't pay nearly enough attention to it.

603
01:01:49,000 --> 01:01:54,000
And it is an 800-pound gorilla.

604
01:01:54,000 --> 01:01:56,000
At the end of the project.

605
01:01:56,000 --> 01:02:03,000
Now, salvage value you will add to the last year of free cash flow.

606
01:02:03,000 --> 01:02:10,000
Again, salvage value you add to the last year of free cash flow.

607
01:02:10,000 --> 01:02:17,000
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.

608
01:02:17,000 --> 01:02:20,000
It will be 2000 plus 3000, 5000.

609
01:02:20,000 --> 01:02:23,000
Don't get confused by that in a problem I give you.

610
01:02:23,000 --> 01:02:24,000
Here's the thing.

611
01:02:24,000 --> 01:02:29,000
Salvage value can be positive or negative.

612
01:02:29,000 --> 01:02:35,000
Salvage value, whether you use it or not, you have to include it.

613
01:02:35,000 --> 01:02:41,000
Companies have equipment at the end of the life of a project.

614
01:02:41,000 --> 01:02:45,000
A lot of companies just drive it to a field and let it die there.

615
01:02:45,000 --> 01:02:47,000
That's what they do.

616
01:02:47,000 --> 01:02:48,000
The factories.

617
01:02:48,000 --> 01:02:51,000
There's a great example out there on GE Road.

618
01:02:51,000 --> 01:02:55,000
If you ever pass the Walgreens, it's on the other side of the Walgreens.

619
01:02:55,000 --> 01:02:58,000
There's a ginormous friggin' factory out there.

620
01:02:58,000 --> 01:03:01,000
It's been dead for years.

621
01:03:01,000 --> 01:03:04,000
And it's still on the books.

622
01:03:04,000 --> 01:03:11,000
The salvage value, they could have sold it right after they decommissioned it out there, but they didn't.

623
01:03:11,000 --> 01:03:13,000
They just let it sit.

624
01:03:13,000 --> 01:03:21,000
So they did not include in their analysis that money that would have come in from that project.

625
01:03:21,000 --> 01:03:27,000
Here in this building, some years ago, there was a room, and it's still part of it's there.

626
01:03:27,000 --> 01:03:28,000
They're opening it up.

627
01:03:28,000 --> 01:03:30,000
But it was a ghastly room.

628
01:03:30,000 --> 01:03:35,000
I know it was always locked, but there was this one time when they wanted me,

629
01:03:35,000 --> 01:03:37,000
when I was still doing a lot of portrait photography and all that,

630
01:03:37,000 --> 01:03:42,000
they wanted me to take photographs of all the people, the administrative people and the faculty.

631
01:03:42,000 --> 01:03:46,000
For a really nice portfolio.

632
01:03:46,000 --> 01:03:52,000
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.

633
01:03:52,000 --> 01:03:54,000
They said, oh no, we've got a room where you can go.

634
01:03:54,000 --> 01:03:58,000
And they took me and they said, is this good enough?

635
01:03:58,000 --> 01:04:00,000
And it was like a cavern.

636
01:04:00,000 --> 01:04:05,000
But all along the walls were these things.

637
01:04:05,000 --> 01:04:08,000
They were old computers, monitors.

638
01:04:08,000 --> 01:04:16,000
I mean, I'm talking about those giant computers that had disk drives.

639
01:04:16,000 --> 01:04:24,000
And they had dial-up modem equipment, phone systems with the wires and the end of the wall.

640
01:04:24,000 --> 01:04:28,000
They had all of that in this room, all over the place.

641
01:04:28,000 --> 01:04:34,000
When they replaced computers with upgrades, they took the old ones down there.

642
01:04:34,000 --> 01:04:36,000
They could have sold those.

643
01:04:36,000 --> 01:04:41,000
Or hell, they could have given them to schools around the underprivileged schools.

644
01:04:41,000 --> 01:04:46,000
The kids would have died to have a computer that was three years out of date or two years out of date.

645
01:04:46,000 --> 01:04:49,000
But they just put the stuff downstairs there.

646
01:04:49,000 --> 01:04:54,000
And so there was an example again of salvage value unrealized.

647
01:04:54,000 --> 01:04:56,000
It happens all the time.

648
01:04:56,000 --> 01:05:05,000
And you have to set out a roadmap at the beginning for what you will do with the equipment when you decommission.

649
01:05:05,000 --> 01:05:08,000
It's just part of what you do.

650
01:05:08,000 --> 01:05:11,000
Now, that's positive salvage value.

651
01:05:11,000 --> 01:05:16,000
Here's the dark side of salvage value, the negatives.

652
01:05:16,000 --> 01:05:22,000
And this is the one that until recently it had been completely ignored.

653
01:05:22,000 --> 01:05:26,000
And then it came back to bite these companies in the ass.

654
01:05:26,000 --> 01:05:34,000
If they had considered it upfront and made arrangements to deal with it at the back end,

655
01:05:34,000 --> 01:05:37,000
they would not have had such catastrophes happen.

656
01:05:37,000 --> 01:05:40,000
Does anyone know the biggest negative salvage value?

657
01:05:40,000 --> 01:05:45,000
Anyone got a stab at it?

658
01:05:45,000 --> 01:05:52,000
Environmental remediation.

659
01:05:52,000 --> 01:06:02,000
When you close down, you would not believe environmental remediation affects almost every project you will undertake.

660
01:06:02,000 --> 01:06:09,000
And if you ignore it and you just bury the crap out there and you just walk away,

661
01:06:09,000 --> 01:06:14,000
lolling your way into the future, suddenly about 10, 15 years later,

662
01:06:14,000 --> 01:06:19,000
you can get a class action lawsuit of a billion dollars from people who are starting to get cancer

663
01:06:19,000 --> 01:06:23,000
because your crap leached into the water supply.

664
01:06:23,000 --> 01:06:25,000
It's all over the place.

665
01:06:25,000 --> 01:06:27,000
And it's not just toxic chemicals.

666
01:06:27,000 --> 01:06:33,000
Things like electronics are environmental catastrophes waiting to happen.

667
01:06:33,000 --> 01:06:35,000
You can't just bury them.

668
01:06:35,000 --> 01:06:37,000
And there are all kinds of other things.

669
01:06:37,000 --> 01:06:40,000
USTs, which are underground storage tanks.

670
01:06:40,000 --> 01:06:42,000
We find them all the time.

671
01:06:42,000 --> 01:06:47,000
Companies twinkle-toed away, sold the land, and then later we find a UST under there.

672
01:06:47,000 --> 01:06:51,000
And so the company that has gone away, forgot all about what it did,

673
01:06:51,000 --> 01:06:57,000
it gets sued back to the Stone Age for misrepresenting the state of the property upon sale.

674
01:06:57,000 --> 01:07:00,000
So this is a major issue.

675
01:07:00,000 --> 01:07:09,000
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,

676
01:07:09,000 --> 01:07:10,000
they will bless you.

677
01:07:10,000 --> 01:07:17,000
Maybe things will change, but at least you will have given them a roadmap out of hell for this.

678
01:07:17,000 --> 01:07:21,000
Another one is what's called tailing liability.

679
01:07:21,000 --> 01:07:27,000
Products that after you close down the project, they can hurt people afterwards.

680
01:07:27,000 --> 01:07:29,000
They can cause all kinds of danger.

681
01:07:29,000 --> 01:07:36,000
Now, if you had included those costs when you first found NPV IRR,

682
01:07:36,000 --> 01:07:43,000
you might have even rejected the project because it would have had such a fat-ass negative salvage value there on the end.

683
01:07:43,000 --> 01:07:46,000
Excellent example of that was private airplanes.

684
01:07:46,000 --> 01:07:52,000
I used to be a private pilot, and you flew Cessnas, the beaches, the Pipers,

685
01:07:52,000 --> 01:07:54,000
well, there were some Pipers out there.

686
01:07:54,000 --> 01:07:57,000
But here was the interesting thing.

687
01:07:57,000 --> 01:08:06,000
Years after those planes were built, they had a funny habit of breaking apart in the sky.

688
01:08:06,000 --> 01:08:08,000
Now, that's a bad thing.

689
01:08:08,000 --> 01:08:14,000
I mean, I'll tell you right now, having a plane with a wing come off really makes you sad

690
01:08:14,000 --> 01:08:17,000
when you're at about 3,000 feet.

691
01:08:17,000 --> 01:08:21,000
When I was first learning how to fly, the instructor said,

692
01:08:21,000 --> 01:08:23,000
tell me about your fears.

693
01:08:23,000 --> 01:08:25,000
I don't know, why are you a psychotherapist?

694
01:08:25,000 --> 01:08:28,000
I said, I'm afraid the plane is going, the engine's going to quit.

695
01:08:28,000 --> 01:08:31,000
And he said, oh, don't worry about that.

696
01:08:31,000 --> 01:08:35,000
Really? Yeah, we'll make it to the crash site.

697
01:08:35,000 --> 01:08:38,000
Really? Yeah.

698
01:08:38,000 --> 01:08:46,000
So anyway, yeah, these planes started breaking in the air, the struts on those high wings.

699
01:08:46,000 --> 01:08:51,000
And then all of a sudden you got this wing saying hi at you and all that.

700
01:08:51,000 --> 01:08:56,000
And so they started getting lawsuits that drove them into bankruptcy.

701
01:08:56,000 --> 01:09:01,000
If they had thought upfront, you buy tail liability insurance.

702
01:09:01,000 --> 01:09:06,000
You say, okay, this is going to be a cost upfront.

703
01:09:06,000 --> 01:09:08,000
We get the quotes for this.

704
01:09:08,000 --> 01:09:10,000
Yeah, it's a lot of money.

705
01:09:10,000 --> 01:09:14,000
But if you don't do it, you're probably going to pay a hell of a lot more.

706
01:09:14,000 --> 01:09:16,000
It will come back to haunt you.

707
01:09:16,000 --> 01:09:20,000
That positive NPV project turns out to be a negative NPV project.

708
01:09:20,000 --> 01:09:22,000
Well, that tells you something, Cupcake.

709
01:09:22,000 --> 01:09:24,000
We don't do this project.

710
01:09:24,000 --> 01:09:27,000
Instead of, well, let's just ignore it and then it's okay.

711
01:09:27,000 --> 01:09:32,000
I would, you know, some of you know that I used to run a paranormal society,

712
01:09:32,000 --> 01:09:35,000
ghost hunting club here on campus.

713
01:09:35,000 --> 01:09:40,000
Okay, you can either look at the building and you can say this is haunted AF.

714
01:09:40,000 --> 01:09:43,000
Or you can go in there and then you have to deal with someone in the crowd

715
01:09:43,000 --> 01:09:46,000
getting demonically possessed and then you've got a real problem.

716
01:09:46,000 --> 01:09:49,000
I have to go down and get them from hell and I've got meetings.

717
01:09:49,000 --> 01:09:52,000
I can't do that for a couple of weeks and then they're all bitching at me.

718
01:09:52,000 --> 01:09:53,000
That's all I have for you today.

719
01:09:53,000 --> 01:10:06,000
I thank you.