Alan Cring Productions in association with Emergent Light Studio presents
the Illinois State Collegiate Compendium, academic lectures in business and economics.
This is business finance, FIL 341 for Autumn Semester 2024.
Free cash flow and the impact of depreciation.
This is an advanced, more advanced version of the Excel spreadsheet that I had brought,
that I've shown you already, that I showed you on Tuesday of this week.
This one allows you to use straight line or double declining balance depreciation.
And we're going to look at what happens and why depreciation is in some cases the game changer
in whether a project is accepted or rejected.
And also look at the effects of such factors as tax rates on whether projects are accepted or rejected.
And sometimes the results of that are a little on the surprising side.
And your textbook takes you up to the point where you're using bonus depreciations
and other very simple ideas in depreciation.
This is more realistic.
It is admittedly that you're seeing one only for your project.
But at the same time it's allowing you a little bit more flexibility in how you conceptualize,
how you quantify whether a project is a go or a no go.
And that's always gold for us in our business is actually have models
that you can build on and certainly if you want to keep this model for other classes,
like for example the MBA, if you went for an MBA,
you would run into the same kind of problem in there and you would have a leg up
because you would be able to do this.
And that reminds me if you haven't done the Excel certification or if you already have done it,
just get it uploaded before the assignment deadline after the Thanksgiving break.
And like I said, if you need some help with it, let me know.
But you can use, I'd prefer that you use the best one out there right now.
It's probably Udemy, although Wall Street Prep is strong.
And if you get it done here, you're not going to have to do it
as some of the other professors for our advanced courses in the 300 level.
They're going to require that you do Wall Street Prep.
So if you've already got a certification, you just say I'm already done.
You've got it done here or you did it for me in FIL 240.
So there is a longer term payoff to getting this done for me now in this course.
And like I said, if you already have a cert, just upload a screenshot of it
and you got your credit from me for it.
And that's an easy bunch of points for the course.
Now, starting out, we'll have a look at the markets here for a little bit
just to see what's going on.
And as you can see, there were a couple of real hits to the stock market
over the last couple of days.
One of the big ones, what was the one that went down 20% yesterday?
Do you know?
Target, 20% down.
They missed their earnings.
And I mean, come on, I mean 20% down on an earnings miss.
Wow, that hurts.
I'm going to show that one to you.
It's just, that was spectacular.
And I had one of my former students who's a trader, he said,
do you know what the F happened to Target?
And I said, well, they had a bad earnings report.
He said, not worth 20%.
Now, usually in a situation like that, you'll see a bounce back the next day.
Matter of fact, anytime there's a real steep drop, there is actually,
I've seen different numbers, but there's about a 70% chance
that the next trading day it will have a recovery.
So on a drop, buy a call.
Just, you'll make a little money off it because there will be a correction.
There will be the drop, the punishment, and then you'll have the bargain hunters
come running in and grab it up.
Because Target is not going to go into bankruptcy.
Target is here for the long haul.
So that kind of a beating is just not, I mean, that's just plain cruel.
But anyway, today, if we're looking at the markets today, we do have an up day.
And you notice something interesting about today is that it's bullish on all of the ones that I look at.
But interestingly enough, it's in the opposite order.
The Dow is up 1.25% right now.
We're still trading.
And then the S&P 500 is up about 2 thirds of a percent.
The NASDAQ is up less than a quarter of a percent.
So usually the Dow is up the least, the S&P 500 is up more,
and the NASDAQ is the one that's rip-snorting upward the most.
And in this case, we're seeing exactly the opposite kind of behavior.
And it's, and I brought this up on Tuesday.
There is a great deal of concern for the future, but especially if we have a global tariff war.
But at the same time, that would be less of a, have less of an impact on very large,
the largest of the large corporations.
And that impact would be more felt by the S&P 500 companies,
and it would be absolutely catastrophic for NASDAQ companies.
It would be the end of it.
Now, interestingly enough, in the same regard, before I go any further,
one sector that is always on the front burner for people to talk about
is one of the technology sectors, chip makers.
Now, very quickly here, let me show you the two big chip makers.
AMD is sort of right now the love child of the geek community.
Better than Intel, yeah, Intel sucks.
Intel's got problems with its chips and all this kind of stuff.
So AMD has been having sort of a run recently.
If you look over the last year, it's actually been highly volatile.
And that, you look right here, and you can see the beta is up there in the high 1.71.
It's been bouncing around, but it is staying pretty strong.
The odd thing is right now, if you look at these declining tops, see that?
That's a classic pattern. I've talked about it before.
You've got declining tops.
Now, however, you also have something along the line of flat or slightly flat bottoms.
If you look over here, for the last couple of months, you have declining bottoms as well.
That's a very dark sign for a chip maker.
For any company, when you have declining tops and declining bottoms,
that is pointing to some kind of a trouble down the line for the stock.
It's a technical indicator, whether it's right or not.
Well, who knows?
INTL, try that, INTL.
Intel.
Now, Intel, what the hell?
Oh, that's one year away.
What? I'm unclear on why this sucks.
Oh, there's not much of the day gone yet.
They're not listing much of the day.
So you see, Intel is actually climbing right now.
Over the past year or so, it got this bad reputation in the last few months.
And admittedly, Intel does have a rather bad flaw in one of its latest generation of chip sets.
A company that is suffering the consequences of that, because it uses the higher end of those chips,
is MSI, which is the gamers, one of the big gaming computers.
And I have an MSI Titan, and it started scaring the hell out of me.
I bought it about two months ago.
There's Intel chips in this i9 series, 14th generation, are all crashing.
It hasn't for me yet, and I'm wondering how much of that is true and how much of it is just scuttlebutt.
But as you can see, declining tops, declining bottoms.
So what the F is going on with this?
Now, the one explanation is that now we are really concerned about a trade war with China.
China makes chips, and that would mean that these kinds of companies would be in huge trouble.
The price of the chips would go through the roof, and so too would the price of the computers that are holding those chips.
And it might get so bad that people do something really, really awful, they might buy Apple computers.
So I didn't say that, if you own an Apple computer.
But no, okay, now, here's the upshot.
Background research.
What are these companies doing as far as manufacture goes?
AMD is not doing much of anything.
They're just saying, we'll be okay.
Intel has turned, there's a part of central Ohio around a little hole in the wall,
hillbilly backwater, where some of my family used to live called Johnstown.
Intel has basically bought about a zillion acres, including Johnstown,
and they're putting up a chip manufacturing plant right in the middle of Ohio.
Now, why did they do that?
Well, that was a decision that was made a couple of years ago,
because they were concerned about shortages of chips if they kept relying on China.
Now, this manufacturing facility is not online yet,
but if there's a trade war, Intel will do a lot better than AMD will.
The downside of that, though, is that we'll still have a shortage of chips.
Intel can't make enough chips for all the computers that are running Linux.
So there will still be a jackup in the price of computers.
Let's go over here and see if the market is reacting on that.
Dell.
They sell bad computers to every university in the country.
Dell is not showing much of a reaction.
It's slowly crawling up.
It's spiked up in the middle of the spring, it was.
And you notice it's got rising tops, rising bottoms right now.
So we might consider that to be something for a long haul.
This might not be a good idea to buy, but right now,
the technical analysis is telling us, yeah, this is a good deal.
Now, if we go for some of the other computer manufacturers,
I'm thinking it's Compaq.
No, it's not a public company, I don't think it is.
Yeah, it's a private company.
We could try to go over here, have a look at MSI.
It's not a public company, I don't think it is.
No, that's Motorola Solutions, MSI.
What's another computer company that's public right now?
Come on.
I'm trying to think of another computer company that's public.
There's Dell, there's Compaq, there's MSI.
There is Asus, I think they're a private company.
Yeah, well, that's a foreign company.
So anyway, not much that we can tell from what we're looking at here.
But anyway, let me go back over to the numbers here just to have a look.
The big one right now, obviously crude oil, it's had a little day up,
but it's still in that trading band from about 68 to 70, 72.
And so we're going to see gas prices stay low.
That's good news.
However, we go over here, we see gold is just slowly crawling upward.
Like I said, the neckline, the resistance level that scares us is $3,000 an ounce.
We're not near there yet, so good news on that.
Now, well, I wish they would have, there's almost no logic to what they're doing here.
The Hong Kong, it's down a little bit, nothing to write home about.
Nikkei, as usual, it's down and it has that typical pattern.
It drops hard at the beginning and then it just floats.
That's what's happening every day, I swear.
So and then we go over here.
One last look, here's the bonds.
And I'll be a son of a bitch if they are rising, those yields are.
Like I said, the magic, oh my God, is 4.5%.
Right now we are fortunately, what, 18 basis points away from it.
But if we get to that, that's very bad news for the economy about six to nine months down the line.
And then these are the same ones as before.
I just wish they wouldn't give all these numbers in different orders.
I can't even see the FTSE right now.
I don't even know, oh, there it is.
London actually is having a little bit of a good day.
They're not quite at the end, I don't think, but they're rising, so we're fine there.
But in our world, we do want to keep an eye on the political situation as it impacts such things as taxes, tariffs.
And now for the day's spreadsheet.
Now you have one called free cash flow, and I'll show you that one here real quick.
And that was the one that I showed you on Tuesday.
It has some very simplistic assumptions in it, but there you are.
Now, let me go over here to student view.
Here's another one for you.
Free cash flow with depreciation.
I hope I uploaded it. Yeah, there it is.
Free cash flow with depreciation.
Now this one will do a real depreciation, either straight line or double declining balance.
I can also put in, I was going to put in another one, but Excel makes that one really complicated.
It's VDB, I believe it's called, and that one has a pain in the butt provision,
which uses a start depreciation that's a fraction of a year and an end depreciation that is a fraction of a year.
And how that relates to what we would want to do is a little bit speculative.
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.
So now, this is going to look a little familiar to you, but this is, now as you see, the first round,
let me back this up a little bit so you can see the whole thing on your screen.
There we go.
Now in this one, you can choose straight SL or DDB.
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.
Now as far as many of, now okay, how many of you remember how many years there are for different classes of capital assets?
If you raise your hand, I'll say you lie.
It could go anywhere from five years up to 45 years, depending upon the project type.
Now those long ones are usually for buildings, which might actually be something here, but I didn't do it that way.
The shorter ones are for things like new computer systems and high technology kinds of things.
And the logic there is that the lives, the economic lives of high technology equipment, their useful lives are very short.
In some cases, companies, back in the day, companies would just say, we will change these computers in ten years.
And some of them held on quite a while.
In fact, I teach international students over in Williams Hall, and they have a computer room over there.
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.
You get Windows 98 on those computers, which of course is insane.
They are just an open pit for any kind of hacking on earth.
There's no security possible on those.
And then they finally, apparently, they are now talking about maybe it's time to upgrade the computers over there.
Gee, you think, but normally companies used to have a life expectancy of ten years on computers.
Now, realistically, I'm changing computers, upgrading every three years, and it'll probably have to advance beyond that.
So computer companies now are getting really serious because you can have all the fanciest software in the world,
but if your computer isn't strong enough to handle it, as you may know with Windows 11, Windows 10,
Windows 10 is being deprecated and it won't be supported without a fee after the end of this year, I believe it is.
So companies know, okay, if we want the hottest software, we have to have the hottest computers.
So that's why it's five years.
Now, in this case, as you can see, this is a little bit different kind of analysis.
I'm going to have to back it off one more.
I hope you can see it. You can still see it up there.
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.
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,
make it a little easier, and I will try, I don't know how, MACRS is a type of variable declining balance system,
and it gets really complicated when you get into the fractions of years.
So the ones that I've chosen, and then I would ask you about play with it.
Just try it out. See what happens when you do this kind of thing.
Now, you can do this for the project under consideration.
First of all, notice the straight line depreciation.
It has its biggest impact because you are taking away the same amount every year,
and that means that your tax shield stays the same every year.
In the double declining balance, as you can see, your depreciation expense is heavier.
Your tax shield is bigger at the beginning, and therefore the shield has a higher present value at the beginning,
the tax shield component does.
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.
Now, there is an interesting thing that happens here.
Notice something about what happens in this.
Now, your salvage value, I've got to fix that, it looks like.
But looking down here, if I go to straight line depreciation, SL,
in either case, you are not going to have a particularly good time here.
But, anyway, but notice that in the straight line, at the end, you have this number.
Notice the free cash flow in the terminal year.
Now, let me go back to the double declining balance.
Watch this number right here.
You get a larger salvage value at the end.
Something is going on here.
But, anyway, now another thing that we can look at.
Look at the growth rate of revenues.
Suppose that we have a growth rate of revenues of 5% on DDB versus straight line.
Let me go back.
Double declining balance.
It has the net present value that is larger than if you use straight line depreciation.
So the depreciation, even though it is not a real cash flow,
it does have an impact on our choice of whether to go or no go with a project.
Let me bring down the discount rate to 7.5%.
That's with a straight line.
Now, let me go with DDB and see if...
Almost there.
Let's try 7%.
So with 7%, we accept the project if we are using double declining balance.
But if we use straight line, we reject the project.
That is the impact of depreciation and the choice of depreciation methods that you use.
Now, no one in practice would probably use straight line anymore,
but it's good for the emphasis on how important this is.
Now, I want to take you on a little journey here real quick.
This won't be much longer.
I won't keep you too long today.
It's almost the break.
DDB out.
Suppose that we cut the tax rate to 15%.
You notice that we have a positive NPV project.
If we're using NPV decision making, we say go.
But let's cut the tax rate down.
It becomes better.
Let's take the tax rate down a little further to 10%.
Now, suppose that the new president, he has promised to zero out the corporate tax rate.
So essentially, whether we accept or reject projects is very sensitive to the corporate tax rate.
That's why he's doing it.
Corporations would just love to see this because more projects would have positive NPVs
and there would be a much more aggressive investment rate because of that higher NPV.
The problem though is that the weighted average cost of capital for companies that use debt,
the tax shield arising from the deductibility of the interest expense,
and I don't include that in this model,
but if that would have an impact on the weighted average cost of capital without that 1-T on the R sub D,
then there would just be the cost of debt.
And in a rising interstate environment, which we have now,
that could cause these wax weighted average cost of capital to go up
as there was no more tax shield on debt.
And that would be detrimental to projects.
So you've got one force that will be up if we zero out the corporate tax rate,
that will be in favor of higher NPVs,
but lower taxes on free cash flows would be facing lower taxes.
However, the other side of it is that zeroing out the tax rate
would mean there would be no more tax deductibility of interest expense on debt,
which would raise the cost of debt,
which would raise the cost of the weighted average cost of capital.
So as one force was working in favor of positive NPV projects,
the other force would be working against positive NPV projects.
And if we have a strong inflation, that will help the corporate profit lines too.
But we have to keep this all in mind,
that we are going to have two forces that are going to be pushing in opposite directions.
And this project analysis here gives you a little bit more meat to play with.
Let me put the growth rate down to zero.
And let me get this back up here.
Back to just looking at it real quick here.
Let me put it back to 8.5 percent and look at DDB.
Okay, this is a negative NPV project.
Let me put it at 7 so we get something happy here.
And let's do straight line.
Now, DDB.
I thought 7 percent got me a little bit.
Oh, put the expected inflation rate, put the tax rate back up to 21 percent.
I don't know why it was.
So 21 percent, 7 percent, 0 percent.
Huh, still a negative NPV project.
Let me bring it down to 5 percent.
There we go.
Okay, the one last thing that you can do is you don't have to have constant growth.
If you have projections of your own for the revenues over the four-year life of this project,
you can certainly put those in here as well.
We would say, well, the first year we're going to have maybe about 400,000 in revenue.
And then the second year we're going to grow that to 500,000.
And the third year, well, let's say 525,000 as it peaks out.
And then in the last year we have, let's say, 350,000.
You can certainly put all, any numbers you want in there, your own revenue projections.
Now, as you saw, I put in constant growth rate of,
and you can include that here in the expected inflation that would include a constant growth rate.
Say 3 percent inflation and 2 percent growth in revenues.
You could certainly do it that way.
And you could get that.
So you can do your own thing here, however you want to do it.
So this is going to help you with problems that you would have in homework.
I might put a really lightweight problem on the last quiz on the final exam
just to show you that you can use these templates to get your answers.
If you don't have any more for me, I'm going to, when we come back next week,
we're going to cover a last material, a quiz in class on Tuesday.
Thursday I review you for the final and then we're done.
That's all I have for you today. I thank you.