The first principle, if you remember, was that all cash flows of a project or a new idea, or an existing idea's expansion have to be incremental. By that, I mean the following, you have to, and just to give you a sense of what does it mean on the timeline, please try and do to analyses. And I believe we had a ten year horizon for a project. So this will be without project. Because life goes on and it's called status quo or whatever. So don't assume that nothing is happening. Unless, of course, this is a brand new project and idea. Even then, it's good to think about the world without the idea and then with the idea. This is with the project. And the value creation is the difference between this and this. So if this was A1 through A10, this is B1 through B10, it's the change that is value created. I think I've written this a little bit fast because you've already seen it. So I would recommend very strongly to you to do two analyses, every time until you get so used to doing the differences in your head, okay? Research shows that people who are early on in the profession cannot easily think changes in their head. They have to do it in a deliberate way until it becomes part of you. And then about 10 years down, after experience with doing analysis and thinking about ideas, you do it almost in your head. And advantages of doing it explicitly is that you cannot make mistakes, or your mistakes become few. You don't double count, you don't forget opportunity cost, you don't forget sunk costs and so on. And you don't forget thinking about what the world would look like without the project. I think that's extremely important. So what I'm going to do next is go on to the next principal which is do not forget the importance of time 0, we talked a lot about it. And we didn't spend that much time on the last year of the chosen timeline, and I'll talk about it in a second later. But in the beginning at time 0, why is it important? Because at time 0 something has happened, which are different from time 1 and so on. And those things are called capital. You need capital. And the difference between capital and the cash flow, C1 and so on, is that one is a stark that's used throughout the process of the project, right? So what are the two kinds of capital? The two kinds of capital is one is Cap X, which is buying machines and so on and the other is working [COUGH] capital. And both come from where? The balance sheet. That's where assets reside. And so whenever you're thinking of capital, always think changes, it's not the level, because it's a snapshot, the balance sheet, okay, we talked about this last time. What I'm going to do now is move on to the next principal, which is accounting issues are extremely important. And the reason why I'm going to emphasize this is to remind you that this class is not about accounting, but accounting is a language you need to be very aware of. And just some examples that we talked about, which are important ones, is the notion of, just let me write a couple of things down for you. So the notion of depreciation Is important because it's an entirely fictitious creation, trying to replicate something that's important in life, how much of the machine you use, but it's fictitious, so it's an accounting measure. Similarly, when you sell equipment at the end of a business and make a gain on selling the equipment, there are some tax implications which are accounting based. Finally, working capital, which we talked about, has to be thought of carefully, why? Because you have to have account receivables, account payables, inventory, you have to think about all those issues. And understanding how accounting works is important. Fundamentally, what you want to do is you want to take accounting statements, which is the language of business, but which is limited, as I said. Languages are, you want to convert it into real stuff, cash flows or real value every year. And that requires some knowledge of what your language is, to be able to convert it into reality, right? So that's the one issue that I really emphasize and going back to it for one more time, please, when you have the time, try to acquire knowledge of accounting, it will be extremely helpful to you. The next principle is that whenever you're doing analysis of real assets, remember, this is what generates the C's, don't touch this. Or as MC Hammer said, you can't touch this. And the reason is financing is inherently included in the cost of capital, r. And by the way, starting today, after we have done the review, guess where we're going, we are going to financing. And the reason we are going to the financing is because we want to figure this out. But financing shouldn't be the primary determinant of the value of your assets, because the assets are what create value. So, for example, imagine if you went to buy an iPad versus Samsung's version off a notebook, would you ever wonder whether Samsung has debt versus Apple? Or do you just look at the product? I've never seen anybody ask, by the way, if iPad is produced entirely with debt, I'm going to touch it, even though it's the coolest thing under the sun. It's a silly thing, right? So financing is not the first thing that pops to your mind when you think of value, you think of the product that you're going to buy, or the service. So that's extremely important. The second thing, as I said, financing is inherently included in the cost of capital, which is r. And by the way, I use the lingo of finance, but hopefully you're now familiar with things like cost of capital, interest rate, saying the same thing, right? So R, little r and cost of capital are the same thing. Moving on, and notice I'm going a little slower, and the reason is these are really important things. The whys of valuation, if you may, and the important things to remember. What does inflation have to do with things? So remember, you're doing C1, C10, right? But you're standing here, what will happen to the prices of all your revenue items, costs of goods sold and everything? They're going to change. So P1 will be different than P10 And for each item. So for your commodity you're trying to sell, there'll be inflation at a different rate, and so on so forth. You've got to include it so you'll have quantities. Q1 times P 1 either figuring out revenues or cost of goods sold. Don't forget that these should be changing, and it's pretty easy to get data on how different prices have behaved in the past and include them. And the reason is quite simple. When we go to R, it has inflation built in. Inflation is included in our and the notion is very simple. If the interest rate is not going to come and say to you inflation, then what the heck is doing? I mean, that's the general intuitive idea of why inflation is always in the interest rate, right? So please keep that in mind that's important and notice we are almost done. But the last one is probably something that's of great practical importance. Remember, I gave you an idea of two projects Hey and be And they looked like this minus 20 million minus. Do minus two million 12 this is the first kind of machine you could buy and taxes have been taken into account, depreciation, everything. Don't worry, let's just stick with these are the costs involved or you could buy this machine. And I think I got the numbers right. And in the earth, three negative, one million. The first thing that jumps out at you is the following. That these are not equally lived are equal length machines, but one doesn't think of that right? So, typically what happens is you tend to compare the cost directly and pick the lower cost one. In this case, it's a little bit complicated because you have to include these costs too, right? And why is this one million versus two million because maintenance is lower for a more expensive machine. So what I'm going to do is I'm going to go over and show you the PVs of the tour. Yeah, Okay, so let's do this, I have already done it. So if you stare at the first row, you have minus 20 minus two minus two, minus 25 minus one minus one minus one is in row two. So what is 23.72 if you notice and now you're cool. You can do all the stuff. You've done a lot of practice, so I'm not going to go through the steps. You notice that the PV of the first machine is 23.72 PV of the second machine is 27.7 two. And remember, these are costs. So how do you if you're doing the costs on the analysis? How do you create value by choosing the lower cost, right? And remember, these days, with the economy being what it has been at the U S for a long time, cost minimization is a primary way of value creation. And don't underestimate its power. We all love great ideas, but they come very seldom. And the one thing I have against the way we teach, especially at business schools, is we sell something as o positive. NPV ideas are just floating around for you to just go pluck off 10 of thin air. No, it takes a lot of effort to create value and the reason is you got to be better than the competitor, right? It's very tough anyway, so the cost is higher for which machine the more expensive one right, which is largely because of the five million today. So now the question is, which machine would you choose, people choose the first machine. What is the problem with that choice? Right away, you recognize the problem is that the least low, expensive, low cost machines tend to last for a shorter interval. That's kind of built in not always, but built into why it's lower cost and we forget about that. So what do you want to do? You want to compare the 21 way to do it is to make the horizon six years. Then you'll have replaced the first machine once and the second machine. Sorry first machine twice and the second machine once. Right now, that's a long way of doing it, right? Basically, you're making a horizon finances so awesome. You just need to convert these two numbers into four year, but keeping accounting and keeping time value of money in mind. So let's do it, let's convert this to an annuity. How would you do it? You'll do PMT remember, PMT is already already per year and what's the nature of the beast? It's a fixed number. So what is the number I gave into PMT. The first number is give us point five, which is the interest rate I've used for doing this. Next second number is number of periods, right? Harmony, too. The third number, which, by the way, I or sometimes forget, is BV versus every here it's BV and with sellers BB in. I believe it's an air four and if I got this right, it says error for some reason, let's figure out what it is, okay? Its point of five two and that's period. Okay, Ryan here caught me and my look at my fingers. They go all over the place, okay. 12 0.76 that means what the 12.76 adjusted for time value of money is the courier cost. Look at the power of that little concept, it takes care of time, value of money and everything. What is the second one? Let's do it slowly so that you understand what I was talking about. Yes, 0.53 and where is the amount sitting in? Hey, what do you notice? Actually with machine really by it's very obvious which one? You're not going to buy the cheap machine because on a four year time value adjusted basis, it's $2 million more, right? So you see how dramatic finances it forces you to look forward and it just for time and most of us forget this, by the way, I forget it. Many times I get attracted by ideas that cost less, right. So when I used to buy jeans, I used to buy jeans the cheapest possible, by the way, I loved blue jeans. It's one of the best inventions ever. So when you go buy jeans cheap, then analyzed every six months, I was having to replace them because it was not good, they were falling apart. Then I started buying expensive jeans, and the good news is, they are expensive many times twice, but they last forever. I can't get rid of them. So if you stare at the screen now, I what I've done for you is I've listed all the principles again, and I know sometimes I go slow. Sometimes I go fast, but it's by design. When things are really important, I want you to understand them, and this is something that applies to every project. Every idea. Money, no money. This is how you should think. Okay. You think about life, love, whatever in this way. And it'll kind of uplift you. Think about the future. Think about it clearly. Yet we use your heart to while making decisions, right? That finance allows you to use your head and your heart. Okay, let's move on to something that's a new stuff. So before I go there, let me just revisit one idea that is the length of the timeline. And that's another thing that I keep talking about the timeline timeline, timeline. But here, just a little pause. Remember I told you that the beginning of a project is an important point, but the end of the project is also an important point, and I deliberately stayed away from talking about it for a little while. And the reason is we are going to move on to the notion of bonds and stocks today. And the reason I'm going to bonds and stocks, remember, is financing. And the reason we are going to financing is because we want to figure out for this purpose, for our costs are course we want to figure out what the cost of capital R is and how do you get it? And that's what it's all about. Of course, you want to understand financing from a personal standpoint, and the nice thing about whatever we do next is born stalks risk. It's personal. In other words, you can think like an investor or a person who is going to invest later. So except for cash flow estimation for a project which you may or may not do until you work or have an idea or whatever, you can use everything else for personal decision making and thinking. And remember, even if you don't have money, this is so cool. Okay, so let me show you what the end of the project looks like. Remember, our project was 10 years long. At the beginning, you should think of things which I said had capital in them. And they are negative. Usually right. You have to spend stocks of things to start some flow. Okay, what happens here if the project is over, you just close shop. You sell inventory, etc. Basically, working capital comes back, [SOUND] and the notion is you're not going to use this working capital anymore. You also sell machines. So whatever capital happened in the beginning, you kind of undo it. It's not the same value, obviously, especially the machine, so you just undo it. And at that point, you have to take care of taxes and stuff like that. Just briefly for machine has been depreciated fully and you sell it for 10 bucks. You have to pay taxes on that. On the other hand, if you haven't depreciated it fully accounting wise and 10 bucks is the value of the machine, and you haven't depreciated five. You're allowed to depreciate five and pay taxes only on five things like that you learn as you go along. What's important today is suppose this is not true. I suppose you think the project will go on, and that's the difference between the project and affirm. A firm does go on. Projects may or may not go on, so projects have finite lives. Firms do not have finite lives. When you're thinking about them in the future right, you don't start a new idea and say it's going to be there only for two years. It's not a very good new idea, and it's not an empowering way to start something. Because if you are not that excited about its longevity, nobody else is going to be all right. So what do you do here? Remember, the last cash flow here is C 10. We did an example where this was 1.9 million and this could be hopefully, say, 20 million. That's the last period's cash flow. And what is cash flow? Net of all the expenses. Okay, so now what do you do? Suppose you're expected to go on. You figure out how long it's going to go on, take all its present value here all the years here future and put it here. And you use simplistic formulas to do that. And the reason is very simple. All the value beyond your 11th to whatever you cannot estimate precisely. In fact, I would encourage you to only do precise estimation for things that are we know a lot about Right. I spoke about that. Your horizon should be dependent on how much you know, rather than are the world knows rather than something fixed, right? So you're 11 and onwards can be thought of the following way. It's called terminal value, and we'll be using these formulas a lot today. That's why I'm introducing it. Terminal value can be thought of C11 over R minus G. Remember I told you a formula of something that lasts forever is C over R minus G. I'm going to use it a lot today, and this is called a perpetuity. This guy is called the perpetuity. What is g, g is the growth rate and you'll apply to how much? 20 million. So what, we'll C11 be, 20 times, one plus g. How will you get g? G will be your estimation of how much growth you'll have after your 10. And what is R, how is sorry for writing it in caps? It's our same old little art, So I just wanted to lay it all out here is that you have two choices in a project. A project could end and you could sell the inventory. You could do all that and you could stop. Or you could think of a project like a firm which goes on forever. You can't do both. You can't stop and get value beyond your tent. We'll come back to this and the reason I'm highlighting this is we are moving on to think about ongoing things and ongoing things are called firms.
