While these videos are supposed to provide you as much knowledge as I'm capable of conveying, it's not so much supposed to help you do the problem as so much as to understand why things work the way they do. I think the only way you learn actually, and I found this for myself is if you practice. There are very few things in life, which afford you the flexibility and the opportunity to just apply something you've learned right away. I've said this many times to you, I love finance because I can apply it to everything. Now obviously, don't sit at dinner and start drawing graphs and pull out the Excel spreadsheet to figure out whether you really love your family or not. That's really getting to be a little sick but the way of thinking is so cool. Please do the assessments and assignments. I think that's your way of empowering yourself. Moving on today the rest of this week is what I call decision criteria. By that I mean, how does one decide whether one is creating value or not? Till now, most of the problems that we have done, most of the applications we have done are personalized. By that I mean, you should be able to relate to them and understand because the world is taking loans, that's the inherent piece, we are investing for the future personally, or you're thinking about doing it, or you're thinking about starting a job and how to save. All of those were part of what we have done. We are going to change a little bit. The reason is we want to use the same tools to start thinking about how does the world work? How am I creating value with the new idea? What is the way I assess whether I'm adding value? Now, a lot of this happens within what we call corporations. Let me just set up a context for you. But I want to emphasize this is as personal as the earlier piece. It just allows you to think about corporations and other things. You start with an idea and we call it a project. You can call it anything you want, and it could be as simple as, do I do this class? Remember, I want to emphasize over and over again, don't think just money. There's a famous economist at Chicago, Gary Becker, whose class I was very fortunate to take. Who has used economics to things that you could never imagine. He used economics to provide value to human beings and it was human capital, one of the pioneers. When he started that, there was a lot of pushback because humans shouldn't be valued. I agree that humans shouldn't be valued only in terms of money. Because regardless of what we may think of ourselves as being very competitive even in the US, not all people are born equal. In my view, money is not the main reason to value people but I want to just emphasize that. Your idea could be smart. This principle will still apply, however, give you a little flavor. What is a firm or a company or a corporation? Well, it's just a bunch of ideas. It's ideas happening over time and if you google you somehow seem to come up with brand new ideas. Why was Steve Jobs so awesome? Because he convinced you to buy something you really didn't need. You know what I mean? I mean, this genius that he was was unbelievable that he's passed, he's gone unfortunately at a young age, but we still are enamored by what he created. Value creation comes through good ideas, projects. Today's session is to talk about how do you assess or determine what is a good idea project. I want to warn you of one thing, I'm not only going to talk about what is a better way of assessing a good idea but I'm also going to talk about what is used in the real world. To give you a sense, modern finance that we're talking about today emerged in 60s, 70s. As it emerged, it emerged from the great universities of the US largely and other universities too but the US came up with the model of research in universities and spending a lot of thought on thinking about which has added a lot of value to society. Modern finance was developing in the '60s, '70s, '80s, but it took 30 years of development for things to change. Some fundamentally powerful ideas took 30 years to be implemented in the real world. Yet, the real-world continues to use things that don't make any sense. Honestly don't. They can make sense in certain contexts, but I will highlight issues and concerns with not only things that are good to use that you quote on quote should use. But also ideas and evaluation methods that are used in the real world which are really slippery. What are the properties of a good decision criteria? I want to lay those out and I have just thought about these. I think the one thing that's helping me honestly in creating this class is because I don't have you live with me. It's forcing me to think a lot more about things that are in my mind that are obvious to me. But I think that's helping me become a better teacher. I hope that this experience not only benefits you, but also benefits me and future students. It's makes me a better teacher. That's what I want to be. For example, a good decision criteria should make sense. What does that mean? Is that the gain should exceed the pain. Now today again, I will identify all the gain and pain benefits and costs with dollar signs on them. But again, do not please forget. That your benefits and costs can come in non-pecuniary or non-monetary ways. Those are as important to think about. But the framework, the belief here is you will not take an act, you not do an act that imposes more pain on you, then the fun or the good things you feel from the idea. We'll just use money to evaluate those. Is there other times when you may do something that is more painful to you seemingly to benefit somebody else more? Sure. But we'll stick with this notion that for the most part, the benefits to you exceed the costs. This is a philosophical issue at some level, but we'll stick with this. Unit of measurement. Now, to be honest with you, you do these things over and over and you don't think about fundamentals. I was sitting there just yesterday and I realize that unit of measurement is such a key thing. But we take it for granted because we work with this all the time. I'm going to emphasize that as I go along, it is very important. The question here is, so you come up with a criteria. What is the unit of measurement the criteria uses to evaluate things is extremely important. Third thing, we're using a criteria. What's the benchmark? How do you determine whether something is in the good area versus not so good versus bad? A benchmark to do that is critical. Again, something that's obvious, but not so obvious when you really start thinking deeply, you just do plug and chug and you're not thinking about things. Easy to communicate. Why have I picked this? I think easy to communicate is extremely important if you want it to be successful in the real world. You can do all the research sitting in an ivory tower, but especially in business, where it's an applied field. If you are not able to communicate your thoughts, the use of it won't be very high. I genuinely believe that. By easy to communicate, I don't mean you make the thing look easy. In fact, I'm making your life harder by explaining why forcing you to think, than just plug and chug with a calculator. Easy to communicate means not that the concept is easy, but you have to find a way of making people feel this makes sense, I get it. Very important. You don't look at one idea at a time though many times we'll set it up as such. In real life, you have several ideas, especially if you're a corporation. A lot of people working for you and you have a lot of pressure, hopefully of very smart people coming up and saying, look, this is a great idea, and so you may end up comparing ideas. The question is, how does the criteria or criterion allow you to compare ideas? That's a very important point. Easy to calculate. Why I'm I throwing that out there? It's just as a reminder that not very long ago we didn't have so much power on our desktops. Some of the hang-ups we have from the past may be because we were hung up on how things can be calculated in an easy way. Of course, I always leave something open for ideas that you may have, and you can talk among yourselves. This is not an exhaustive list. Each item is not exclusively different from the other. There's overlap, but I want you to recognize this as you're looking at any criteria for anything, you want this at the back of your mind. Let's get started. If you want to take a little break right now and think about what I've said, it's not a bad idea. Just pause. But I don't think you need to take a significant break because we've just set up what we're going to talk about. I will highlight as I go along where I think that it may be a good idea to take a longer break. Let's get started. The first idea is called net present value. As always, I'm going to introduce that idea with an example. I think you'll be able to relate to this because of what we have spent time doing in the past couple of weeks and this morning. This is a very simple example. I'm not simplifying it because I think the world will have simple examples, but I do believe if you recognize this little example, you'll recognize the importance of NPV for whatever problem you face. Assume that the interest rate is 10 percent. What is the NPV of the following idea? Let me just say it. I know you can see this very clearly, but let me just articulate what I'm saying so that you remember what the timeline looks like. Year 0 is a point in time, one is a point in time. How many periods have elapsed between zero and one? one period. This is another way of writing a timeline. cashflow. As I said, the word cash is unfortunate here. Just think of it as a negative hit or a positive hit. What's happening at time zero? You're making an investment of about $1,000, and the negative sign is extremely important. It's an outflow. Many times it'll show up in red in Excel. If you're putting numbers in Excel, please put it as a negative number. Why is it negative? Why I'm I assuming that any idea has an outflow in the beginning? Well, most great ideas are actually very intense on the outflow up front. It takes a lot of effort, money, people, resources, to come up with a fantastic idea. It doesn't happen easily. There is always pain in the beginning, the better the idea, may be more the pain. The pain is reflected in the negative sign. Let's go over to the second point and time. After one period, this project is over. Now, clearly, life is not like that. A project hopefully last as long as you want it to, if you're successful at it. But let's keep it simple. After one year, there is a positive inflow of 1,320. Now, let's move over to the next column. How many years do I need to discount? Why I'm I talking about discounting? Because remember, I'm trying to either carry the 1,000 to the future or bring the 1,320 to today. The reason is very simple. One year passing means I just cannot compare the two. Another way to think about this problem is this, let me just emphasize something obvious. Think of these as apples, and think of these as oranges. I can't even spell and I'm supposed to be teaching. That's something to go. Ryan, he's helping me and he's laughing with me, and I hope you're laughing too. Why am I calling time apples and oranges? Because if you get that 0.0, 1, 2, 3, 4 are different things and you have to somehow purge the effects of time, you'll always remember that. What makes you purge the effects of time? The time value of money. The question to you is, let's do some calculations. What is the value of minus $1000 today? How many years of discounting do you need to do? None. You have minus 1000. However, there's good news. You're going to make some money out of this idea or feel some benefit from it. The problem is, it's not happening right away. It's happening one year from now. If it were happening right away, you are a genius. You are an absolute genius. You put $1000 in one side of your pocket and somehow in the other side, 1320 emerges. If you can do that, you don't need to take this class, you are all set already. However, in life, it takes time, it takes pain, it takes passage of time, is one way of getting gains. You'd get 1320 but one year from now. Can you tell me its present value? You'll see why I took 10 percent. You should be able to, because how much am I discounting by? Ten percent. Which means what? I take 1320, and I'm going very basic and divide by 1 plus r. I'm trying to figure out this one. That is 1320 divided by 1.1. Is that right? Look what happens. I can easily multiply by 11. I've set up the 1320 so that I can, so 1200. Simple. We'll use Excel, but we don't need to use Excel to do this problem and that's the point. Excel is only needed to do the problem because it has strange numbers if you may. This is 1200. If I didn't do this right, let's confirm. 11 times 1 is 11, 22 times 2 and because there's a decimal, there's another zero. What is the NPV? Turns out now you can add, and this is the principle to remember. After you have purged the effects of time, you can add numbers. Isn't that awesome? This becomes $200. Let's make the problem very interesting. Everything is in million because lot of people find it uninteresting to do 200 bucks worth of an idea so let's make it a million and if that makes you happy. The present value of the future amount is this much. But what did I do to get the NPV? This is very important. I took the 1200 and I subtracted the 1000, so I'm left with 200. Why did I subtract the 1000? Because if I don't subtract the 1000, it's like I have a money machine. I'm getting 1200 without any effort, without any input. That's impossible unless you find one and then you can let me know. Hopefully, we are friends by now and we can share things. But if you have a money machine, as I said, you don't need to be here. Actually, you do if you want to learn. 1200 minus $1000 is 200 bucks. Quick question. Just very quickly. Where does the phrase or the expression net present value come from? I always want to see what they're talking about. Let's stare at it for a minute. Where is present value coming from? The fact that I can't compare oranges to apples, I have to bring everything back today. Why today? Because I'm making the decision today. You could do this decision time traveling as if it's 100 years from now, but why make it 100 years from now when you're standing today. Present value's obvious. Where does the net come from? This is very important, the trivial. Net comes from the fact that I have to subtract my investment. This guy is the reason why it becomes net. Please remember, there's a big difference between present value and net present value though many times I'll use them at the same time in the context it's obvious. I hope this was helpful to you. Very simple problem, but I'm going to now show you how actually it's not simple.
