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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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Free cash flow and the impact of depreciation.

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This is an advanced, more advanced version of the Excel spreadsheet that I had brought,

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that I've shown you already, that I showed you on Tuesday of this week.

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This one allows you to use straight line or double declining balance depreciation.

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And we're going to look at what happens and why depreciation is in some cases the game changer

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in whether a project is accepted or rejected.

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And also look at the effects of such factors as tax rates on whether projects are accepted or rejected.

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And sometimes the results of that are a little on the surprising side.

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And your textbook takes you up to the point where you're using bonus depreciations

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and other very simple ideas in depreciation.

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This is more realistic.

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It is admittedly that you're seeing one only for your project.

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But at the same time it's allowing you a little bit more flexibility in how you conceptualize,

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how you quantify whether a project is a go or a no go.

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And that's always gold for us in our business is actually have models

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that you can build on and certainly if you want to keep this model for other classes,

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like for example the MBA, if you went for an MBA,

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you would run into the same kind of problem in there and you would have a leg up

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because you would be able to do this.

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And that reminds me if you haven't done the Excel certification or if you already have done it,

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just get it uploaded before the assignment deadline after the Thanksgiving break.

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And like I said, if you need some help with it, let me know.

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But you can use, I'd prefer that you use the best one out there right now.

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It's probably Udemy, although Wall Street Prep is strong.

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And if you get it done here, you're not going to have to do it

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as some of the other professors for our advanced courses in the 300 level.

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They're going to require that you do Wall Street Prep.

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So if you've already got a certification, you just say I'm already done.

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You've got it done here or you did it for me in FIL 240.

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So there is a longer term payoff to getting this done for me now in this course.

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And like I said, if you already have a cert, just upload a screenshot of it

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and you got your credit from me for it.

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And that's an easy bunch of points for the course.

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Now, starting out, we'll have a look at the markets here for a little bit

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just to see what's going on.

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And as you can see, there were a couple of real hits to the stock market

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over the last couple of days.

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One of the big ones, what was the one that went down 20% yesterday?

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Do you know?

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Target, 20% down.

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They missed their earnings.

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And I mean, come on, I mean 20% down on an earnings miss.

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Wow, that hurts.

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I'm going to show that one to you.

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It's just, that was spectacular.

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And I had one of my former students who's a trader, he said,

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do you know what the F happened to Target?

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And I said, well, they had a bad earnings report.

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He said, not worth 20%.

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Now, usually in a situation like that, you'll see a bounce back the next day.

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Matter of fact, anytime there's a real steep drop, there is actually,

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I've seen different numbers, but there's about a 70% chance

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that the next trading day it will have a recovery.

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So on a drop, buy a call.

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Just, you'll make a little money off it because there will be a correction.

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There will be the drop, the punishment, and then you'll have the bargain hunters

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come running in and grab it up.

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Because Target is not going to go into bankruptcy.

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Target is here for the long haul.

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So that kind of a beating is just not, I mean, that's just plain cruel.

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But anyway, today, if we're looking at the markets today, we do have an up day.

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And you notice something interesting about today is that it's bullish on all of the ones that I look at.

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But interestingly enough, it's in the opposite order.

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The Dow is up 1.25% right now.

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We're still trading.

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And then the S&P 500 is up about 2 thirds of a percent.

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The NASDAQ is up less than a quarter of a percent.

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So usually the Dow is up the least, the S&P 500 is up more,

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and the NASDAQ is the one that's rip-snorting upward the most.

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And in this case, we're seeing exactly the opposite kind of behavior.

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And it's, and I brought this up on Tuesday.

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There is a great deal of concern for the future, but especially if we have a global tariff war.

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But at the same time, that would be less of a, have less of an impact on very large,

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the largest of the large corporations.

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And that impact would be more felt by the S&P 500 companies,

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and it would be absolutely catastrophic for NASDAQ companies.

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It would be the end of it.

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Now, interestingly enough, in the same regard, before I go any further,

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one sector that is always on the front burner for people to talk about

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is one of the technology sectors, chip makers.

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Now, very quickly here, let me show you the two big chip makers.

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AMD is sort of right now the love child of the geek community.

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Better than Intel, yeah, Intel sucks.

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Intel's got problems with its chips and all this kind of stuff.

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So AMD has been having sort of a run recently.

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If you look over the last year, it's actually been highly volatile.

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And that, you look right here, and you can see the beta is up there in the high 1.71.

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It's been bouncing around, but it is staying pretty strong.

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The odd thing is right now, if you look at these declining tops, see that?

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That's a classic pattern. I've talked about it before.

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You've got declining tops.

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Now, however, you also have something along the line of flat or slightly flat bottoms.

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If you look over here, for the last couple of months, you have declining bottoms as well.

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That's a very dark sign for a chip maker.

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For any company, when you have declining tops and declining bottoms,

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that is pointing to some kind of a trouble down the line for the stock.

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It's a technical indicator, whether it's right or not.

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Well, who knows?

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INTL, try that, INTL.

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Intel.

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Now, Intel, what the hell?

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Oh, that's one year away.

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What? I'm unclear on why this sucks.

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Oh, there's not much of the day gone yet.

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They're not listing much of the day.

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So you see, Intel is actually climbing right now.

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Over the past year or so, it got this bad reputation in the last few months.

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And admittedly, Intel does have a rather bad flaw in one of its latest generation of chip sets.

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A company that is suffering the consequences of that, because it uses the higher end of those chips,

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is MSI, which is the gamers, one of the big gaming computers.

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And I have an MSI Titan, and it started scaring the hell out of me.

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I bought it about two months ago.

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There's Intel chips in this i9 series, 14th generation, are all crashing.

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It hasn't for me yet, and I'm wondering how much of that is true and how much of it is just scuttlebutt.

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But as you can see, declining tops, declining bottoms.

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So what the F is going on with this?

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Now, the one explanation is that now we are really concerned about a trade war with China.

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China makes chips, and that would mean that these kinds of companies would be in huge trouble.

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The price of the chips would go through the roof, and so too would the price of the computers that are holding those chips.

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And it might get so bad that people do something really, really awful, they might buy Apple computers.

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So I didn't say that, if you own an Apple computer.

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But no, okay, now, here's the upshot.

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Background research.

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What are these companies doing as far as manufacture goes?

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AMD is not doing much of anything.

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They're just saying, we'll be okay.

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Intel has turned, there's a part of central Ohio around a little hole in the wall,

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hillbilly backwater, where some of my family used to live called Johnstown.

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Intel has basically bought about a zillion acres, including Johnstown,

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and they're putting up a chip manufacturing plant right in the middle of Ohio.

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Now, why did they do that?

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Well, that was a decision that was made a couple of years ago,

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because they were concerned about shortages of chips if they kept relying on China.

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Now, this manufacturing facility is not online yet,

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but if there's a trade war, Intel will do a lot better than AMD will.

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The downside of that, though, is that we'll still have a shortage of chips.

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Intel can't make enough chips for all the computers that are running Linux.

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So there will still be a jackup in the price of computers.

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Let's go over here and see if the market is reacting on that.

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Dell.

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They sell bad computers to every university in the country.

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Dell is not showing much of a reaction.

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It's slowly crawling up.

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It's spiked up in the middle of the spring, it was.

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And you notice it's got rising tops, rising bottoms right now.

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So we might consider that to be something for a long haul.

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This might not be a good idea to buy, but right now,

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the technical analysis is telling us, yeah, this is a good deal.

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Now, if we go for some of the other computer manufacturers,

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I'm thinking it's Compaq.

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No, it's not a public company, I don't think it is.

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Yeah, it's a private company.

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We could try to go over here, have a look at MSI.

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It's not a public company, I don't think it is.

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No, that's Motorola Solutions, MSI.

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What's another computer company that's public right now?

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Come on.

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I'm trying to think of another computer company that's public.

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There's Dell, there's Compaq, there's MSI.

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There is Asus, I think they're a private company.

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Yeah, well, that's a foreign company.

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So anyway, not much that we can tell from what we're looking at here.

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But anyway, let me go back over to the numbers here just to have a look.

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The big one right now, obviously crude oil, it's had a little day up,

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but it's still in that trading band from about 68 to 70, 72.

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And so we're going to see gas prices stay low.

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That's good news.

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However, we go over here, we see gold is just slowly crawling upward.

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Like I said, the neckline, the resistance level that scares us is $3,000 an ounce.

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We're not near there yet, so good news on that.

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Now, well, I wish they would have, there's almost no logic to what they're doing here.

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The Hong Kong, it's down a little bit, nothing to write home about.

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Nikkei, as usual, it's down and it has that typical pattern.

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It drops hard at the beginning and then it just floats.

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That's what's happening every day, I swear.

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So and then we go over here.

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One last look, here's the bonds.

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And I'll be a son of a bitch if they are rising, those yields are.

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Like I said, the magic, oh my God, is 4.5%.

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Right now we are fortunately, what, 18 basis points away from it.

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But if we get to that, that's very bad news for the economy about six to nine months down the line.

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And then these are the same ones as before.

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I just wish they wouldn't give all these numbers in different orders.

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I can't even see the FTSE right now.

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I don't even know, oh, there it is.

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London actually is having a little bit of a good day.

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They're not quite at the end, I don't think, but they're rising, so we're fine there.

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But in our world, we do want to keep an eye on the political situation as it impacts such things as taxes, tariffs.

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And now for the day's spreadsheet.

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Now you have one called free cash flow, and I'll show you that one here real quick.

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And that was the one that I showed you on Tuesday.

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It has some very simplistic assumptions in it, but there you are.

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Now, let me go over here to student view.

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Here's another one for you.

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Free cash flow with depreciation.

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I hope I uploaded it. Yeah, there it is.

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Free cash flow with depreciation.

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Now this one will do a real depreciation, either straight line or double declining balance.

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I can also put in, I was going to put in another one, but Excel makes that one really complicated.

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It's VDB, I believe it's called, and that one has a pain in the butt provision,

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which uses a start depreciation that's a fraction of a year and an end depreciation that is a fraction of a year.

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And how that relates to what we would want to do is a little bit speculative.

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It's not going to change much as far as the outcome goes, but it's certainly going to complicate the problem a lot for analysis purposes.

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So now, this is going to look a little familiar to you, but this is, now as you see, the first round,

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let me back this up a little bit so you can see the whole thing on your screen.

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There we go.

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Now in this one, you can choose straight SL or DDB.

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Now I've done an SL, and as you can see, it is declining this down, straight line, over four year life of the project.

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Now as far as many of, now okay, how many of you remember how many years there are for different classes of capital assets?

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If you raise your hand, I'll say you lie.

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It could go anywhere from five years up to 45 years, depending upon the project type.

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Now those long ones are usually for buildings, which might actually be something here, but I didn't do it that way.

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The shorter ones are for things like new computer systems and high technology kinds of things.

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And the logic there is that the lives, the economic lives of high technology equipment, their useful lives are very short.

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In some cases, companies, back in the day, companies would just say, we will change these computers in ten years.

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And some of them held on quite a while.

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In fact, I teach international students over in Williams Hall, and they have a computer room over there.

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And when you turn on the computers, what you get is not Windows 11, not Windows 10, not Windows 8 or 7, not Windows Vista.

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You get Windows 98 on those computers, which of course is insane.

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They are just an open pit for any kind of hacking on earth.

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There's no security possible on those.

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And then they finally, apparently, they are now talking about maybe it's time to upgrade the computers over there.

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Gee, you think, but normally companies used to have a life expectancy of ten years on computers.

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Now, realistically, I'm changing computers, upgrading every three years, and it'll probably have to advance beyond that.

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So computer companies now are getting really serious because you can have all the fanciest software in the world,

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but if your computer isn't strong enough to handle it, as you may know with Windows 11, Windows 10,

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Windows 10 is being deprecated and it won't be supported without a fee after the end of this year, I believe it is.

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So companies know, okay, if we want the hottest software, we have to have the hottest computers.

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So that's why it's five years.

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Now, in this case, as you can see, this is a little bit different kind of analysis.

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I'm going to have to back it off one more.

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I hope you can see it. You can still see it up there.

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Now, in this one, and this is for a four-year project, but the difference here is that you are putting in the depreciation method.

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You would use SL for straight line and you would use DB, DDB for, and I can turn that into a drop-down menu for you as well if you want,

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make it a little easier, and I will try, I don't know how, MACRS is a type of variable declining balance system,

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and it gets really complicated when you get into the fractions of years.

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So the ones that I've chosen, and then I would ask you about play with it.

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Just try it out. See what happens when you do this kind of thing.

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Now, you can do this for the project under consideration.

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First of all, notice the straight line depreciation.

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It has its biggest impact because you are taking away the same amount every year,

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and that means that your tax shield stays the same every year.

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In the double declining balance, as you can see, your depreciation expense is heavier.

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Your tax shield is bigger at the beginning, and therefore the shield has a higher present value at the beginning,

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the tax shield component does.

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And then, of course, when you add it back in, the add back in is bigger in the early years than it is in the light years.

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Now, there is an interesting thing that happens here.

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Notice something about what happens in this.

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Now, your salvage value, I've got to fix that, it looks like.

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But looking down here, if I go to straight line depreciation, SL,

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in either case, you are not going to have a particularly good time here.

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But, anyway, but notice that in the straight line, at the end, you have this number.

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Notice the free cash flow in the terminal year.

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Now, let me go back to the double declining balance.

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Watch this number right here.

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You get a larger salvage value at the end.

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Something is going on here.

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But, anyway, now another thing that we can look at.

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Look at the growth rate of revenues.

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Suppose that we have a growth rate of revenues of 5% on DDB versus straight line.

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Let me go back.

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Double declining balance.

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It has the net present value that is larger than if you use straight line depreciation.

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So the depreciation, even though it is not a real cash flow,

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it does have an impact on our choice of whether to go or no go with a project.

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Let me bring down the discount rate to 7.5%.

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That's with a straight line.

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Now, let me go with DDB and see if...

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Almost there.

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Let's try 7%.

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So with 7%, we accept the project if we are using double declining balance.

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But if we use straight line, we reject the project.

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That is the impact of depreciation and the choice of depreciation methods that you use.

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Now, no one in practice would probably use straight line anymore,

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but it's good for the emphasis on how important this is.

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Now, I want to take you on a little journey here real quick.

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This won't be much longer.

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I won't keep you too long today.

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It's almost the break.

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DDB out.

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Suppose that we cut the tax rate to 15%.

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You notice that we have a positive NPV project.

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If we're using NPV decision making, we say go.

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But let's cut the tax rate down.

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It becomes better.

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Let's take the tax rate down a little further to 10%.

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Now, suppose that the new president, he has promised to zero out the corporate tax rate.

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So essentially, whether we accept or reject projects is very sensitive to the corporate tax rate.

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That's why he's doing it.

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Corporations would just love to see this because more projects would have positive NPVs

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and there would be a much more aggressive investment rate because of that higher NPV.

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The problem though is that the weighted average cost of capital for companies that use debt,

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the tax shield arising from the deductibility of the interest expense,

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and I don't include that in this model,

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but if that would have an impact on the weighted average cost of capital without that 1-T on the R sub D,

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then there would just be the cost of debt.

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And in a rising interstate environment, which we have now,

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that could cause these wax weighted average cost of capital to go up

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as there was no more tax shield on debt.

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And that would be detrimental to projects.

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So you've got one force that will be up if we zero out the corporate tax rate,

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that will be in favor of higher NPVs,

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but lower taxes on free cash flows would be facing lower taxes.

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However, the other side of it is that zeroing out the tax rate

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would mean there would be no more tax deductibility of interest expense on debt,

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which would raise the cost of debt,

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which would raise the cost of the weighted average cost of capital.

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So as one force was working in favor of positive NPV projects,

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the other force would be working against positive NPV projects.

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And if we have a strong inflation, that will help the corporate profit lines too.

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But we have to keep this all in mind,

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that we are going to have two forces that are going to be pushing in opposite directions.

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And this project analysis here gives you a little bit more meat to play with.

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Let me put the growth rate down to zero.

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And let me get this back up here.

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Back to just looking at it real quick here.

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Let me put it back to 8.5 percent and look at DDB.

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Okay, this is a negative NPV project.

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Let me put it at 7 so we get something happy here.

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And let's do straight line.

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Now, DDB.

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I thought 7 percent got me a little bit.

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Oh, put the expected inflation rate, put the tax rate back up to 21 percent.

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I don't know why it was.

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So 21 percent, 7 percent, 0 percent.

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Huh, still a negative NPV project.

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Let me bring it down to 5 percent.

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There we go.

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Okay, the one last thing that you can do is you don't have to have constant growth.

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If you have projections of your own for the revenues over the four-year life of this project,

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you can certainly put those in here as well.

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We would say, well, the first year we're going to have maybe about 400,000 in revenue.

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And then the second year we're going to grow that to 500,000.

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And the third year, well, let's say 525,000 as it peaks out.

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And then in the last year we have, let's say, 350,000.

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You can certainly put all, any numbers you want in there, your own revenue projections.

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Now, as you saw, I put in constant growth rate of,

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and you can include that here in the expected inflation that would include a constant growth rate.

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Say 3 percent inflation and 2 percent growth in revenues.

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You could certainly do it that way.

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And you could get that.

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So you can do your own thing here, however you want to do it.

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So this is going to help you with problems that you would have in homework.

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I might put a really lightweight problem on the last quiz on the final exam

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just to show you that you can use these templates to get your answers.

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If you don't have any more for me, I'm going to, when we come back next week,

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we're going to cover a last material, a quiz in class on Tuesday.

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Thursday I review you for the final and then we're done.

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That's all I have for you today. I thank you.