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Alan Cring Productions in association with Emergent Light Studio presents

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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, extensions of capital budgeting decision making.

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And I'm going to do a couple of different, I'm going to pull up a spreadsheet that I've already shown you.

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And I've added a little bit to it. I've talked about it. I mentioned it last time, but I've gotten it sophisticated up now.

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And then I'm going to show you another worksheet that will be relevant for next week, our last week of class.

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But first, a quick look at the numbers.

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And Yahoo has decided that it's going to change its format because obviously everyone was screaming for them not to have important information across the top.

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So as miserable as this is, we've got, it is definitely a bare day.

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And you can see that it is, it's consistently across the big markets.

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Dow is down about four-tenths of a percent. So is the S&P 500.

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The Nasdaq isn't down as much, but the Russell 2000 is down too.

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So that consistency gives us that clear indication that this is a sour day.

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And as you can see from the news, that we have a bit of a concern now because we have a couple of inflation indicators that are warning, flashing warning.

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And so that may put the Fed on a track to not cut the discount rate as it had planned to near the end of the year.

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Now the challenge here is that the last time the fellow who was the president in 2017 to 2021,

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the last time he was in office, he was threatening to fire the Federal Reserve Board of Governors,

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which he can't do, but it was still kind of rattled them if they didn't keep cutting, keep interest rates low.

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Well, that's a real problem now because if we really do have a little spark or an ember of inflation, we need to kill it and kill it very quickly.

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And so I would imagine that the Fed is going to hold off on cutting the discount rate at the end of the year at its final meeting of the FOMC,

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simply because it may not have much of a chance to fight inflation starting next year, or at least it will have a lot of headwinds from the White House.

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So we're going to have to fight it right now.

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That's going to suppress the markets because the markets formed their expectations on the interest rates falling,

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the discount rate being cut in December, and it's not going to be cut possibly.

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And so the markets are on a little bit of a sour note on that.

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Just before I get to a little more of that, crude oil is staying in that very tight trading range I was talking about on Monday.

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It seems to be very comfortable there.

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We are a wash in oil in the reserves on the high seas at the refineries and in the pipeline. It's just a very good supply of oil going into the Christmas season,

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which is we want it to be for people driving to shopping malls, trucks driving stuff to stores and all that kind of good stuff.

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Now, if we go over here and I'm looking, come on, we are not. Oh, I hate this layout.

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Yes, I do.

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Ten-year bond has eased up a little on its interest rates for the time being.

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Now, that is on a buying. There's been buying of bonds.

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It's not too much of a flight to quality, but there does have a little bit of a hint that equities are being sold

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and the proceeds, at least some of them, are going to buy bonds, pushing the bond prices up, pushes the bond yields down.

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So this may be a very minor flight to quality, waiting to see what happens next.

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We do have a couple of other issues that are kind of playing in here.

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We are getting more countries sending warning messages, open warning messages to the incoming administration.

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Don't start a trade war. It will be a disaster, not just for your country, but for the world in general.

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And so you've got small countries and large countries openly and behind in back channels saying, don't even try that.

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Unfortunately, it's probably going to happen. And so the results are going to be as one would expect.

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There we go. Why am I struggling here to find what I want?

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Well, the FTSE is actually kind of surging this morning, or at least now it closes in just about 20 minutes, I think.

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But it's been showing some signs of life, which is good news for London, not for us.

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We need to. And this is just a mess the way they've got this set up now.

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So I can't really tell what's your own next. Hansang.

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I can't. This is I may have to go to another service from now on if Yahoo is going to be this kind of be pissy like this.

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But I mean, right now, the markets are in a wait and see kind of attitude.

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And we just got to sort of live with that for the time being, because we don't know what's coming next.

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I'm curious to see how the VIX. The VIX should be calming down right now, but I'm not sure about that.

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Yeah, well, yeah, it's a little bit. I mean, it's pretty much stable. The volatility is stable from where it was yesterday and all that.

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As you can see, I'm kind of curious about what that drop that was a real hard drop in the vol and then it came back up again.

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And sometimes that's like reading tea leaves. What does that mean? Does that tell us anything about what's about to happen?

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Some people are really into that kind of stuff. But one way or the other, let me go on to the content here.

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This shouldn't take too much time, but I do want to make sure that you know.

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Remember, your capital budgeting decision making methods are payback and PV and internal rate of return.

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Now, taking you over, let me show you a couple of files that you're going to want. And I've already shown these to you.

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And this is sort of like just catching getting a running start here. We're going to go into your canvas folder.

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I'm going to do things a little backwards here. I'm going to show you what the new one is that you will use next week.

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And then I'll go back and spend more time on the other one. 240 for heaven's sakes.

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341. Now, in your file folder, there's going to be two that we use today in your spreadsheets.

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This one you've seen before, but I've added a little bit to it for your benefit. The MPV download.

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Whoops, I don't want to do that. The MPV and IRR, it's the first one that you're going to want to use that I'm going to talk about.

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This is the one we've been using. And I want to show you. No, good heavens, quit it.

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Bond calculations. Download. No, that's not what I want. For heaven's sakes.

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MPV and IRR. Wow. Okay, there we go. Don't know what I'm thinking here. Okay.

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Now, I apparently did it twice there. Okay. Okay, now the net present value, just use this for quiz.

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I'll have a quiz for you on Wednesday of next week and for the final exam. Just put the numbers in from the problem itself.

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I can't emphasize this enough. Don't be a fighter pilot and read into the problem.

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Anytime you see a math problem, you just find the numbers and get them out of the words and send the words packing.

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And in this one, I'm going to give you either a five-year or a seven-year free cash flow.

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Well, no, I'll give you a five-year. And this is all you have to do.

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I'll give you a five-year, find the MPV, and I'll give you a five-year internal rate of return.

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And I will also have you calculate a profitability index.

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You should be able to clock these in easily, and this will give you the ability to know how to do this.

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And you can keep these spreadsheets for other classes.

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And if you get the idea of how I build the model, you can extend the number of years, whatever you want.

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But this is how it's done.

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Now, another one is, remember I told you about modified internal rate of return, MIRR.

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That's here, too. Just, again, put in the numbers, put in the financing rate and the reinvestment rate,

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and you'll get your answers out. We don't have any problems whatsoever.

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So you can clean up these very easily.

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Now, the one that I did here, I've built a payback period model.

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Now, this will be good for up to six, seven, eight years.

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And all you have to do is put in the free cash flows and your number of, first put in the number of project years.

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I should say that. Put in the number of project years.

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And in this case, you've got a five-year project.

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Now, once you put in five years, it will populate the years.

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Like, for example, watch what would happen if I put in six years.

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It would populate six years on the years.

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I figured out how I can do that without using a macro.

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It's called the sequence function.

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And it's really handy. I haven't used it much ever, and I got started using it, and it's very good.

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But then you put in your free cash flows.

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Let me...

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And what it will do is everything else will be automatic.

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And it will tell you the year and exact to the decimal year what the payback period of the project is.

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So, for example, if I wanted to do, let's say I wanted to do a six-year project.

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I could put in, let's say, a free cash flow of negative $500.

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And we come in with $75 and then $150 and let's say $160.

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Whoop, found the year right there.

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I really don't have to put in any of the other data.

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As soon as it hits payback, I don't even have to fill in the rest of it.

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You can if you want, but there it is.

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And this is just an automatic way to find payback period.

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No sweat whatsoever on that.

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Now, again, I have a crossover rate model.

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Now, I will mention crossover rates.

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The one... I'm sorry, mutual exclusive.

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Well, this is kind of like the mutual exclusive projects.

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This isn't really a crossover. This is mutual exclusive projects.

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The problem with mutually exclusive projects is that oftentimes they don't have the same time period,

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the same time frame.

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So comparing them becomes more difficult because you can have a short project

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which will have a high NPV because they're not taking very...

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discounting very far out in the future.

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But its IRR will kind of suck.

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And then you'll have a longer term project which will have a lower NPV,

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but its IRR, it's got a shallower slope.

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So its IRR comes later.

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So in other words, you'll have one project that is like that with the NPV and the discount rate.

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And then you'll have another project that has a shallower slope.

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See, at these low rates, I mean, it's obviously not as attractive as the steeper slope project.

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But as you get to higher and higher discount rates, that shallower slope begins to shine through.

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It stays positive to higher discount rates.

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Ultimately, this flash in the pan will have a low internal rate of return,

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but it has superior, at least before the crossover, it has superior NPVs.

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And this is a problem, you see, because since a lot of companies, you know, like they use the IRR method,

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they tend, these projects tend to get kind of rejected because they,

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if you've got a hurdle right out here someplace, they're dead.

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But on the other hand, if you're using NPV method, you will probably,

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if you've got discount rates in here, then, discount rates in here,

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then that very short project will be superior.

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The big question is, what do you do?

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Obviously, you could do both NPVs, and you can see for different interest rates,

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okay, the IRR of this is here, the IRR of this is here.

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So you notice that there's going to be a gray area in here

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where this project is going to have a higher NPV than this project.

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And so it's going to probably pretty much dominate the whole thing.

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But if you were to use lower discount rates out in here, then that one's going to be your choice.

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It's got a stronger NPV at low discount rates, okay?

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So what we do sometimes when we look at mutually exclusive projects

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is that we map out the free cash flows of each of the projects.

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And then we look at one as the opportunity cost of the other.

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So in the example that I've given you here, in this one,

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you see that the opportunity cost of project B is project A.

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So in other words, at the very beginning, project A has an initial investment of $30,000.

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Project B has an initial investment of $40,000.

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So if we go with project B, we spend $40,000, but we save $30,000.

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So ultimately, in the crossover analysis, the mutually exclusive part of it is a negative $10,000.

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Again, what we're looking at is project A as the opportunity cost of project B.

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So in the second year, well, in the first year, project B pulls in $20,000.

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You give up the $5,000 from project A to get that.

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So the ultimate result is $15,000 for B as essentially the alternative to A.

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Now you keep going, and I'll repeat this a couple of times.

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If I'm running project B, I will pull in $12,000,

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but that means that I give up the $8,000 from project A.

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And then you just keep going with this, and you will see that as you go down the line,

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it behaves as a switching cash flow problem.

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So the internal rate of return is going to probably, if you do an internal rate of return,

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you'd probably want to do an MIRR, modified internal rate of return.

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But you can stick straight with the NPV, and you can see that the IRRs, if I do this,

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the NPV of project A is at a discount rate of 5%.

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The NPV of project A is on its own. It's $3,000.

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The NPV of project B at 5% is $2,000.

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Now the internal rate of return of project A is 8.75%.

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The internal rate of return of project B is 7.96%.

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Now, that could be the end of it. You could just say, okay, project B,

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project A dominates project B, both on NPV and IRR.

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So we could just say, screw it, project A.

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However, if you do look over there at the A as the opportunity cost of B,

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in other words, we're going to go with B. Let's say we go with B,

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and we look at what happens if you consider A as its opportunity cost.

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Remember we use a weighted average cost of capital of 5%,

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and we use an reinvestment rate of 7% to get this.

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See, this has to be an MIRR simply because it has this switch in cash flow side.

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See, it switches once, twice, and then three times.

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So you can't use a straight-up internal rate of return.

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You have to look at it, a modified internal rate of return.

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Now, if you look at it that way, and you say we have a whack of 5%,

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reinvestment rate of 7%, do you see that B is actually a go

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because it returns more than the cost of its capital.

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Its cost of capital was the whack, 5%, but the project B,

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saying, okay, we gave up project A for this, project B is a go

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because it returns more than the cost of its capital, which was whack, 5%.

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So this doesn't necessarily muddy the waters.

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Most of the time, someone would just say project A because it has a higher NPV

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and it has a higher IRR.

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But if you look at it a little more closely, project B is actually the best project

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because it pulls in more than it costs to create it.

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Giving up project A, we get better than what we paid in for project B.

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So that's why we do this kind of crossover, mutually exclusive kind of project analysis.

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Now, there's another question that goes on here too.

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Suppose that you have a situation where one project, let me do this.

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Year 0, 1, 2, 3, 4, 5, 6.

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In year 0, this one costs, let's say, negative $50.

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This one costs negative $70.

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And then in year 1, let's say $5, $10, $15, and then 20, 15,

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and then with salvage value, 10 at the end.

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Project B is, let's say, positive $20, positive $40, no, positive $30, and then positive $25.

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The problem with just comparing these NPV and IRR is that you have a mismatch of years in this.

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This one's going to kick the hell out of this one because it has, you can even see by the payback period,

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it pops on the scene, brings in very large revenues, comparatively speaking,

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and they are for only three years, so the present values of these are very strong

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compared to the present values where this one finds its mojo out here.

207
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So that's what's going on here.

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We can't really compare them, NPV, IRR, right up front.

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So we use a method that makes the number of years equivalent.

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And in this case, what we're going to do is we're going to say we are going to turn Project B into a six-year project.

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And the way we're going to do that is we're going to say, okay, we're going to do Project B twice.

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So in other words, we're going to repeat Project B, call it Project B prime.

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So then when this one is dying, we're going to start it back up again with negative $70,

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and then we're going to get the same free cash flows again, 20, 30, and 25.

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Oops, I didn't mean that.

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I want to put those over here.

217
00:25:13,000 --> 00:25:15,000
I'm sorry.

218
00:25:15,000 --> 00:25:30,000
I want to put these 20, 30, and 25.

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So ultimately, what we have is a project that does B plus B prime.

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We have a project that runs $70, $20, $30, and then negative $45,

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because it will be finishing up with $25, and we'll spend $70 to start it back up again,

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and then 20, then 30, and then 25.

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So in other words, we compare A to B repeated twice.

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And that way, they have the equivalent number of years that they're running.

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Now, obviously, this one for internal rate of return, we need to do an MIRR.

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We have to do it, modified internal rate of return to get to do it.

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But still, this is how we can make the two projects have equivalent years.

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Now, you'd say, well, that was kind of cheating there,

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because it had exactly, project B had exactly half the number of years of project A.

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Well, that's fine.

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We just do it.

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We shift that up if it's four years, and you run that four years,

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and you back that up so that it still comes out to be six years.

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00:26:58,000 --> 00:27:06,000
You just put it starting again wherever it will make a total of six years.

235
00:27:06,000 --> 00:27:08,000
That's all you do with that.

236
00:27:08,000 --> 00:27:09,000
Again, let me explain.

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Let me repeat that.

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00:27:12,000 --> 00:27:18,000
All you do with this is let's say that this project was four years in duration.

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What I would do is then shift this up.

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Watch.

241
00:27:21,000 --> 00:27:33,000
Let me do it this way.

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Suppose that this one actually had four years of free cash flows, let's say $10 here.

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All I do in a case like that is that...

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Get the hell out of me.

245
00:27:51,000 --> 00:27:54,000
All I do here is I just shift this up.

246
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I would start again.

247
00:27:56,000 --> 00:28:00,000
This is one, two, three, four, five.

248
00:28:00,000 --> 00:28:04,000
If I start here, one, two, three, four, five.

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00:28:04,000 --> 00:28:06,000
I'd start here.

250
00:28:06,000 --> 00:28:20,000
I would have negative 70, 20, 30, 25, and 10.

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That, my B and B prime would be then negative 70, positive 20, negative 40, positive 45, positive 40, 25, and 10.

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I just shifted up enough so that it cleared the combination of the projects ended in the same year as the one that was just one run of the project.

253
00:28:53,000 --> 00:28:58,000
You just shifted up to get it to align properly.

254
00:28:58,000 --> 00:29:02,000
Now, I won't ask anything like this on a quiz or a test.

255
00:29:02,000 --> 00:29:06,000
This is just sort of like twisting it around.

256
00:29:06,000 --> 00:29:12,000
In a final course in finance, we would do one like this, but it's really...

257
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It's just Excel again.

258
00:29:14,000 --> 00:29:20,000
Just straight up, that crossover spreadsheet is very static.

259
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In other words, you can't use it for a whole lot, but it just gives you the idea of what we're doing when we make them year-equivalent projects.

260
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Now, of course, I did your break even.

261
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That's easy.

262
00:29:42,000 --> 00:30:00,000
It's almost too easy to do on a spreadsheet, but the one that I want to take you through now is the free cash flow sheet, just so you're comfortable with it.

263
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This is project analysis.

264
00:30:07,000 --> 00:30:13,000
I'm going to shorten this up just a little bit here.

265
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I have to make it a little smaller.

266
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Okay.

267
00:30:23,000 --> 00:30:39,000
This is one of those, thou shalt not touch anything in that peachy pink area, or the blue or the green.

268
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Leave it Tf alone.

269
00:30:43,000 --> 00:30:56,000
This is a relatively simplified demonstration of doing a free cash flow analysis.

270
00:30:56,000 --> 00:31:04,000
It makes some simplifying assumptions, and those are consistent with the book.

271
00:31:04,000 --> 00:31:07,000
Let me explain.

272
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The big pain in the butt, I don't care what anyone says, in doing projected free cash flows, is the stupid depreciation.

273
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Is it going to be straight line? Is it going to be modified accelerated cost recovery?

274
00:31:25,000 --> 00:31:29,000
What is it going to be? Some of your digits, whatever.

275
00:31:29,000 --> 00:31:37,000
Modeling that stupid little thing requires a little more sophistication.

276
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It's not that hard in Excel anymore, because Excel can be very, you can tell it what depreciation type you want, and it'll do it.

277
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I could have done that here, but the book, for the most part, says,

278
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assume that all of your depreciation occurs at the beginning.

279
00:32:02,000 --> 00:32:11,000
You have capital expenditures, let's say, of $600,000 in this example right here.

280
00:32:11,000 --> 00:32:22,000
So the depreciation expense for year zero is the whole amount.

281
00:32:22,000 --> 00:32:28,000
Now some of this author's books call that bonus depreciation.

282
00:32:28,000 --> 00:32:34,000
It is not how it usually happens. However, there are.

283
00:32:34,000 --> 00:32:42,000
These are called listed capital expenditures, and I swear I can't remember.

284
00:32:42,000 --> 00:32:46,000
It's rule 472 or something like that.

285
00:32:46,000 --> 00:32:53,000
There is this list of what you can expense right away as soon as you buy it.

286
00:32:53,000 --> 00:32:56,000
In other words, you don't go through a depreciation schedule.

287
00:32:56,000 --> 00:33:01,000
You just expense it, book value goes to zero instantly on those.

288
00:33:01,000 --> 00:33:10,000
So it's not completely unrealistic, but it certainly simplifies this problem.

289
00:33:10,000 --> 00:33:23,000
Now the consequence of that would be that immediately your book value becomes zero.

290
00:33:23,000 --> 00:33:28,000
Now aside from the fact that that doesn't look pretty on your balance sheet,

291
00:33:28,000 --> 00:33:35,000
it does have a great benefit because at the end,

292
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your salvage value minus your book value is taxed at your tax rate.

293
00:33:48,000 --> 00:34:01,000
So in other words, your net salvage value is going to be,

294
00:34:01,000 --> 00:34:13,000
the net salvage value is going to be the salvage value.

295
00:34:13,000 --> 00:34:22,000
If you're using 100% depreciation at the beginning,

296
00:34:22,000 --> 00:34:28,000
the taxable, again, the taxable salvage value is salvage minus book.

297
00:34:28,000 --> 00:34:31,000
That's everything, that's always.

298
00:34:31,000 --> 00:34:36,000
But if you've already wiped out your book value at the very beginning of the project,

299
00:34:36,000 --> 00:34:42,000
at the end, you're going to be hit with the tax on your entire salvage value.

300
00:34:42,000 --> 00:34:47,000
So in this situation where you've done this,

301
00:34:47,000 --> 00:34:57,000
your tax is going to be T times salvage value.

302
00:34:57,000 --> 00:35:02,000
It won't be T times salvage minus book because book is zero.

303
00:35:02,000 --> 00:35:08,000
So your tax on your salvage will be just your salvage value

304
00:35:08,000 --> 00:35:11,000
because you don't have any book value left.

305
00:35:11,000 --> 00:35:13,000
You wiped it out at the end.

306
00:35:13,000 --> 00:35:16,000
You wiped it out at the beginning, I should say.

307
00:35:16,000 --> 00:35:23,000
That's the big thing in these sheets is that it's assuming a 100% bonus immediate,

308
00:35:23,000 --> 00:35:26,000
depreciate the whole thing.

309
00:35:26,000 --> 00:35:32,000
Now a couple of other items that I'm going to bring up here on this sheet.

310
00:35:32,000 --> 00:35:37,000
At the beginning of a project, now this is a simplification,

311
00:35:37,000 --> 00:35:42,000
you are going to bring in inventory.

312
00:35:42,000 --> 00:35:44,000
You're just going to bring in inventory.

313
00:35:44,000 --> 00:35:48,000
So that is going to hurt free cash flow in year zero

314
00:35:48,000 --> 00:35:52,000
because you have to boost up your inventory.

315
00:35:52,000 --> 00:35:57,000
But in the years in which a project is working,

316
00:35:57,000 --> 00:36:15,000
so in other words, your inventory is going to boost $100,000.

317
00:36:15,000 --> 00:36:19,000
That's an increase in your net operating working capital,

318
00:36:19,000 --> 00:36:23,000
so that is going to be a negative on free cash flow.

319
00:36:23,000 --> 00:36:25,000
You will subtract that.

320
00:36:25,000 --> 00:36:32,000
But then in year one, if your sales stay the same,

321
00:36:32,000 --> 00:36:41,000
you will lose $100,000 and then you'll buy back for the next year $100,000.

322
00:36:41,000 --> 00:36:47,000
So the net is no change.

323
00:36:47,000 --> 00:36:53,000
And then the same here, you'll lose the $100,000 because you're going to sell it,

324
00:36:53,000 --> 00:37:01,000
but then you'll buy it back and so the net will be a change of zero.

325
00:37:01,000 --> 00:37:04,000
So there will be anything for that one.

326
00:37:04,000 --> 00:37:07,000
Now in year three, the same thing.

327
00:37:07,000 --> 00:37:13,000
You're going to sell the $100,000

328
00:37:13,000 --> 00:37:21,000
and then you're going to buy back $100,000 going into that year,

329
00:37:21,000 --> 00:37:24,000
so the change in net operating working capital will be zero.

330
00:37:24,000 --> 00:37:28,000
Now this is assuming that you have flat sales for four years.

331
00:37:28,000 --> 00:37:30,000
That's what we're doing in this.

332
00:37:30,000 --> 00:37:35,000
Now here's the fun one, year four.

333
00:37:35,000 --> 00:37:38,000
The project is over at the end of the year,

334
00:37:38,000 --> 00:37:42,000
so you have zero repurchase of inventory.

335
00:37:42,000 --> 00:37:47,000
So in the final year, you have a negative.

336
00:37:47,000 --> 00:37:52,000
Your inventory falls ultimately by $100,000.

337
00:37:52,000 --> 00:37:56,000
In the first year, it goes up by $100,000.

338
00:37:56,000 --> 00:37:58,000
Then it doesn't change.

339
00:37:58,000 --> 00:38:02,000
This is the change in net operating working capital.

340
00:38:02,000 --> 00:38:08,000
So in the first year, you have a boost that hurts increases in net operating working capital,

341
00:38:08,000 --> 00:38:13,000
decreased free cash flow.

342
00:38:13,000 --> 00:38:17,000
So you have a new $100,000, and then in the first year,

343
00:38:17,000 --> 00:38:21,000
you sell it, buy it back to fill the warehouse,

344
00:38:21,000 --> 00:38:26,000
so you have a net change of zero.

345
00:38:26,000 --> 00:38:30,000
Then in the second year, same thing.

346
00:38:30,000 --> 00:38:33,000
You've sold it, so you've got to bring back, you sell it,

347
00:38:33,000 --> 00:38:38,000
so now you have to bring back in that much inventory for the third year.

348
00:38:38,000 --> 00:38:42,000
So the change is zero in net operating working capital.

349
00:38:42,000 --> 00:38:45,000
Again, I'm just repeating what I said before.

350
00:38:45,000 --> 00:38:49,000
Again, you sell it, so you have to, you sold it off,

351
00:38:49,000 --> 00:38:52,000
so you have to bring it back in, so there's no change.

352
00:38:52,000 --> 00:38:58,000
But in the fourth year, you bleed off that $100,000.

353
00:38:58,000 --> 00:39:01,000
You don't replace it because the project is over in that year.

354
00:39:01,000 --> 00:39:07,000
So you recover that $100,000.

355
00:39:07,000 --> 00:39:12,000
So it boosts at the beginning and drops at the end.

356
00:39:12,000 --> 00:39:16,000
Now the first question might be, well, why do we even worry about it?

357
00:39:16,000 --> 00:39:22,000
Because this is a drain on free cash flow.

358
00:39:22,000 --> 00:39:26,000
This is a replenishment of free cash flow.

359
00:39:26,000 --> 00:39:30,000
The thing is that we're going to do an NPV.

360
00:39:30,000 --> 00:39:40,000
So this $100,000 discounted back here is not as much as the positive $100,000 at the beginning.

361
00:39:40,000 --> 00:39:44,000
So you lost some money, so you lose something here.

362
00:39:44,000 --> 00:39:51,000
Yes, it ends with the warehouse empty, just like it began with the warehouse empty.

363
00:39:51,000 --> 00:39:55,000
However, selling off that $100,000 of inventory

364
00:39:55,000 --> 00:40:03,000
isn't worth as much four years out as it was to buy it at the beginning.

365
00:40:03,000 --> 00:40:07,000
So that's why we have to take both into account.

366
00:40:07,000 --> 00:40:11,000
Now the next thing in this, and I'll go through this again on Monday

367
00:40:11,000 --> 00:40:14,000
just to make sure you're clear on this.

368
00:40:14,000 --> 00:40:22,000
Now the next thing is that you're seeing here, and this is, I don't think your book uses this term,

369
00:40:22,000 --> 00:40:30,000
but it is the correct term, spontaneous financing.

370
00:40:30,000 --> 00:40:36,000
A number of companies, well, we've got this capital expenditure.

371
00:40:36,000 --> 00:40:41,000
Well, do we go out, do we sell stock, do we borrow money, how do we do it?

372
00:40:41,000 --> 00:40:44,000
Well, there is a way that companies do it internally.

373
00:40:44,000 --> 00:40:47,000
They just slow down paying their bills.

374
00:40:47,000 --> 00:40:52,000
More they accelerate their credit sale terms.

375
00:40:52,000 --> 00:40:55,000
In this case, it's modest.

376
00:40:55,000 --> 00:41:05,000
They're just going to make on average that they have $20,000 more at the beginning

377
00:41:05,000 --> 00:41:10,000
than they would have if they had paid their bills the way they used to.

378
00:41:10,000 --> 00:41:15,000
It's just slowing down so that you can, a little bit of your financing

379
00:41:15,000 --> 00:41:22,000
comes from just internal short-term cash management policies.

380
00:41:22,000 --> 00:41:32,000
So if I slow down paying my bills so that I have, I have freed up $20,000,

381
00:41:32,000 --> 00:41:36,000
well that's $20,000 I don't have to borrow or I don't have to sell in stock.

382
00:41:36,000 --> 00:41:42,000
Now at the end, I'll bring myself back, at the end of the project's life,

383
00:41:42,000 --> 00:41:50,000
I'll bring myself back to my previous days payable outstanding as we call it.

384
00:41:50,000 --> 00:41:55,000
So you can see here, see how at the beginning you have a positive $20,000.

385
00:41:55,000 --> 00:42:03,000
In other words, this is helping free cash flow by increasing a current liability.

386
00:42:03,000 --> 00:42:10,000
In other words, you're financing a long-term project with a little bit of short-term cash management.

387
00:42:10,000 --> 00:42:16,000
But then at the end, you go back, you know, that $600,000, that project is over,

388
00:42:16,000 --> 00:42:20,000
so we go back to what we were doing before.

389
00:42:20,000 --> 00:42:25,000
That's why you see this spontaneous financing in here.

390
00:42:25,000 --> 00:42:33,000
So ultimately, you have the change, and another one here,

391
00:42:33,000 --> 00:42:37,000
the change in the operating working capital and all that kind of stuff.

392
00:42:37,000 --> 00:42:40,000
So the bottom line is this.

393
00:42:40,000 --> 00:42:43,000
All you have to, notice that this is a flat model.

394
00:42:43,000 --> 00:42:48,000
It just says we're going to sell 100,000 units every year for four years.

395
00:42:48,000 --> 00:42:51,000
That's all. And then we end the project.

396
00:42:51,000 --> 00:42:53,000
So it's obviously a simplification.

397
00:42:53,000 --> 00:42:59,000
And we're going to set a price of $4.50 per unit on this.

398
00:42:59,000 --> 00:43:06,000
Okay, now, and we say that means, and I should really, this is pink actually,

399
00:43:06,000 --> 00:43:10,000
this is actually pink, should have remembered that.

400
00:43:10,000 --> 00:43:16,000
So in other words, you're going to, revenues are going to be the price per unit

401
00:43:16,000 --> 00:43:21,000
times the number of units you sell.

402
00:43:21,000 --> 00:43:27,000
So now this is where it gets to be more classical pro forma.

403
00:43:27,000 --> 00:43:32,000
Your costs as a percent of revenue are 40%.

404
00:43:32,000 --> 00:43:34,000
You could make that any number you want.

405
00:43:34,000 --> 00:43:38,000
You could make it what that percentage has been for the last year,

406
00:43:38,000 --> 00:43:40,000
the average of the last three years.

407
00:43:40,000 --> 00:43:42,000
You could make it even a target.

408
00:43:42,000 --> 00:43:44,000
You can do whatever you want with it.

409
00:43:44,000 --> 00:43:47,000
I just put 40% there.

410
00:43:47,000 --> 00:43:51,000
Now you're selling general and administrative expenses.

411
00:43:51,000 --> 00:43:57,000
Those are going to be, I'm saying, so 20% of it.

412
00:43:57,000 --> 00:44:02,000
Now ultimately, what that means is that your variable cost,

413
00:44:02,000 --> 00:44:08,000
your unit variable cost is 60% of revenue.

414
00:44:08,000 --> 00:44:09,000
That's all that's saying.

415
00:44:09,000 --> 00:44:13,000
And I just broke it up into two different parts because you'd probably figure two

416
00:44:13,000 --> 00:44:18,000
different percentages for costs of goods sold and for SG&A.

417
00:44:18,000 --> 00:44:26,000
You'd analyze those separately to get your total variable cost percentage.

418
00:44:26,000 --> 00:44:35,000
The next one, you just put in whatever you're told is the initial increase in inventory.

419
00:44:35,000 --> 00:44:42,000
And then you put in the cap, what's your cap, cap X is, capital expenditure.

420
00:44:42,000 --> 00:44:46,000
Now in this case, like I said, super simplifying it,

421
00:44:46,000 --> 00:44:52,000
you expense the whole capital expenditure in the first year.

422
00:44:52,000 --> 00:45:00,000
But we're going to slow down our paying of our bills, an average of $20,000 a year.

423
00:45:00,000 --> 00:45:07,000
So we have $20,000 more for the life of the project.

424
00:45:07,000 --> 00:45:09,000
Life is four years.

425
00:45:09,000 --> 00:45:15,000
Now the book value at the end of the project, now that actually, that should be a pink.

426
00:45:15,000 --> 00:45:16,000
I just realized that.

427
00:45:16,000 --> 00:45:27,000
Because your book value would be your salvage value, $100,000 minus 100% of $100,000

428
00:45:27,000 --> 00:45:32,000
because you took a 100% bonus depreciation.

429
00:45:32,000 --> 00:45:35,000
So you don't really need to calculate that at all.

430
00:45:35,000 --> 00:45:38,000
Tax rate, 21%.

431
00:45:38,000 --> 00:45:44,000
Now we are going to need a net present value, so we have to have a discount rate.

432
00:45:44,000 --> 00:45:49,000
We're going to need an internal rate of return, so we give it a hurdle rate.

433
00:45:49,000 --> 00:45:55,000
Now you notice down there at the end, this model can even take into account some inflation.

434
00:45:55,000 --> 00:46:03,000
But all it does is it's just for the first year, you get your depreciation expense,

435
00:46:03,000 --> 00:46:08,000
your capital expenditure, your spontaneous financing,

436
00:46:08,000 --> 00:46:12,000
and your change in inventory, net operating work and capital.

437
00:46:12,000 --> 00:46:17,000
Technically, the spontaneous financing is part of the change in net operating work and capital.

438
00:46:17,000 --> 00:46:18,000
But I break it out.

439
00:46:18,000 --> 00:46:29,000
So ultimately, in the first year, you are going to spend out of pocket net of tax shield from the depreciation,

440
00:46:29,000 --> 00:46:39,000
net of the cost of the inventory, net of saving $20,000 and all that kind of stuff.

441
00:46:39,000 --> 00:46:45,000
You're going to have a free cash flow of negative $554,000.

442
00:46:45,000 --> 00:46:47,000
And then you live through the project.

443
00:46:47,000 --> 00:46:52,000
Classic revenue minus cost of goods sold is your gross margin,

444
00:46:52,000 --> 00:46:58,000
minus your selling general and administrative expenses brings you to operating margin.

445
00:46:58,000 --> 00:47:03,000
Subtract your taxes, and you get no pat.

446
00:47:03,000 --> 00:47:06,000
And that's all that this does.

447
00:47:06,000 --> 00:47:14,000
Once you're into the project itself, the block, the pro forma actually looks pretty clean.

448
00:47:14,000 --> 00:47:22,000
But then at the end of the project, you will get back to paying your bills the old way.

449
00:47:22,000 --> 00:47:25,000
You'll sell off that inventory, and you won't replace it.

450
00:47:25,000 --> 00:47:28,000
So that will save you $100,000.

451
00:47:28,000 --> 00:47:40,000
And then the salvage value will just be basically the salvage value times the tax rate.

452
00:47:40,000 --> 00:47:57,000
So that's $79,000 is just the 21% times the salvage value, which is $100,000.

453
00:47:57,000 --> 00:47:59,000
And this is your stream right here.

454
00:47:59,000 --> 00:48:04,000
This is the free cash flow for the project, the Holy Grail.

455
00:48:04,000 --> 00:48:08,000
And it's on that that we will make the decision.

456
00:48:08,000 --> 00:48:18,000
Now, at a discount rate of 8.5%, the net present value calculates to be a nice $26,500.

457
00:48:18,000 --> 00:48:20,000
It's a go. Accept it.

458
00:48:20,000 --> 00:48:29,000
If our hurdle rate is 10%, we found that the internal rate of return is 10.39%, so we accept it.

459
00:48:29,000 --> 00:48:39,000
And the profitability index is above 100%, so we would accept it if we do profitability index decision making.

460
00:48:39,000 --> 00:48:41,000
Now, let's look at what would happen.

461
00:48:41,000 --> 00:48:50,000
Let's say that I boost the discount rate, well, let's say 12%.

462
00:48:50,000 --> 00:48:59,000
The NPV goes negative, and the profitability index, of course, goes negative because the NPV did.

463
00:48:59,000 --> 00:49:04,000
So we would reject it if we had used a discount rate of 12%.

464
00:49:04,000 --> 00:49:16,000
But notice, if the hurdle rate isn't altered, then we still accept it if we're using the internal rate of return method.

465
00:49:16,000 --> 00:49:17,000
So let me go back here.

466
00:49:17,000 --> 00:49:28,000
Now, let's see what would happen if we increase the hurdle rate to, let's say, 12%.

467
00:49:28,000 --> 00:49:30,000
Well, then we reject it.

468
00:49:30,000 --> 00:49:34,000
Because the internal rate of return was 10.39%.

469
00:49:34,000 --> 00:49:39,000
That's less than the hurdle rate, so you reject.

470
00:49:39,000 --> 00:49:52,000
So if we put the discount rate and the hurdle rate together, we'd reject it on all three criteria.

471
00:49:52,000 --> 00:49:56,000
But let me take you back for one more thing.

472
00:49:56,000 --> 00:49:59,000
What if there's inflation?

473
00:49:59,000 --> 00:50:02,000
Here's a very interesting part of this.

474
00:50:02,000 --> 00:50:13,000
Suppose that we have, we're projecting an expected inflation rate over the life of this project of 5% per year.

475
00:50:13,000 --> 00:50:20,000
Now, remember this 26,000 and this 500 and this 10.39.

476
00:50:20,000 --> 00:50:22,000
So let's put in 5% inflation.

477
00:50:22,000 --> 00:50:25,000
What you'll do is you'll see the numbers up on top.

478
00:50:25,000 --> 00:50:32,000
See how the second, third, and fourth year, the cost, the revenues, the cost, the SG&A, they all go up.

479
00:50:32,000 --> 00:50:35,000
NoPAC goes up.

480
00:50:35,000 --> 00:50:45,000
Notice what happens to the NPV, the IRR, and the profitability index if there's inflation.

481
00:50:45,000 --> 00:50:53,000
As long as the company can pass along the inflation, inflation does not hurt a company one bit.

482
00:50:53,000 --> 00:50:59,000
Matter of fact, it makes this project more profitable.

483
00:50:59,000 --> 00:51:09,000
So what kills us, inflation, because we have to pay for the goods at higher prices, actually benefits corporations.

484
00:51:09,000 --> 00:51:22,000
As long as they can pass along that inflation to the consumers, their projects become more valuable in an inflationary environment.

485
00:51:22,000 --> 00:51:29,000
So inflation, we want to kill it, but at the same time, corporations are kind of blase about that.

486
00:51:29,000 --> 00:51:38,000
Yeah, okay, fine, but if the inflation keeps going, if the inflation stays like this over the life of that project,

487
00:51:38,000 --> 00:51:42,000
this project just becomes more and more profitable to them.

488
00:51:42,000 --> 00:51:47,000
So notice the profitability index went from 105 to 111.

489
00:51:47,000 --> 00:51:49,000
Yeah, that's what goes on.

490
00:51:49,000 --> 00:51:54,000
That's a little insight in finance that is not very well appreciated.

491
00:51:54,000 --> 00:52:00,000
Inflations hurt consumers, and they hurt businesses that buy supplies.

492
00:52:00,000 --> 00:52:11,000
But as long as they can pass those down the food chain to the lowest entity, which is the consumers, doesn't hurt them a bit.

493
00:52:11,000 --> 00:52:14,000
It just makes it more profitable.

494
00:52:14,000 --> 00:52:19,000
Okay, so that one is that, and that will be mostly for next week,

495
00:52:19,000 --> 00:52:23,000
and I'm giving it to you now in case you want to get ahead on the homework and kill it off.

496
00:52:23,000 --> 00:52:27,000
But remember, I have a quiz on Thursday, on Wednesday of next week.

497
00:52:27,000 --> 00:52:29,000
No, on Thursday of next week, I'm sorry.

498
00:52:29,000 --> 00:52:44,000
But that's all I have for you today. I thank you.