Hi, my name is Bob Holthausen. I'm a Professor of Accounting and Finance here at the Wharton School. And we're going to talk more about of evaluating projects and in this particular lecture be a very quick introduction and then we'll get right into the heart of how you think about analyzing the incremental after tax cash flows of a project. So as we talked about before, if you want to compare different projects or you want to decide which projects to take or which projects to reject, what we learned is that you want to use the Net Present Value Rule to do that. And in particular what we saw was that if a project has a positive Net Present Value It's worth more than it costs, it creates value. And therefore, maximizing the value of the firm is equivalent to taking all the projects that you can that have positive net present values. In some cases you might be in a situation where you have more projects than you can possibly take that are positive net present value projects, simply because you don't have the resources. Either the cash resources or the human resources to invest in all those projects at the same time. And what you would do then, is you would take the combination of projects that you can take that yield the highest total net present value. But again, the net present value rule says, take all the projects that have positive net present values. And we saw that this is consistent with maximizing the value of the firm. So now let's understand exactly what the cash flows are. When we talked about calculating present values before, we just assumed we knew what the cash flows were. Now let's delve into exactly what those cash flows are that we need to analyze associated with a project. So what we want to do is we want to forecast what I'm going to refer to is the incremental cash flows associated with the project. And what that mean is that we're asking how do the after tax cash flows of the organization change because of the project? And there's a couple of things that are key in that definition. First of all, the cash flows that we want to look at are the after tax cash flows. We have to take into consideration what the tax considerations are associated with the project and the other thing that is key here is we're asking how the organization's cash flows change. We are not just looking at this project in isolation, we're looking at this project embedded within an organisation. As we'll see there are three different phases of a project. There's an initial investment phase, there's an operating phase and there's a terminal phase. And here's a timeline, and you can see that the timeline here has the three phases. There's the initial investment phase, there's the operating phase, and there's the terminal phase. So you can see those different phases of the project. In this particular case, I've shown one initial investment going out the door at time zero, but this is just one drawing. You could have a project, for example, where you have investments going on for five years, or 10 years, before you actually get to the point where you're operating. If you think about a company building a theme park, like a Walt Disney building a theme park, they're going to be building that theme park for multiple years before they actually open the doors and people come in and they're actually operating the theme park. So in that case, that initial investment phase could go on for multiple years before you were actually in the operating phase. But what we want to do is we want to take each of these three phases in turn and talk about the cash flows that are associated with them. So when we talk about the Initial Investment phase, there are three types of costs associated with this Initial Investment. One of those is capitalized costs. And those are treated as an asset. Another is non-capitalized costs and those are items that are expensed. And the third are Working Capital expenditures. So let's take each of those in turn. If you have something that, an expenditure that you make, that is capitalized. What that means is it is recorded as an asset. And because it's recorded as an asset, there's no immediate expense associated with the recording of that asset. And then normally what will happen, if that asset is used up over time, it will generally be written off through depreciation over the life of that asset, and the depreciation will actually be the expensing of that asset over time. But because at the time of purchase the expenditure is capitalized, what that means is, there's no immediate tax benefit associated with purchasing that equipment unless there's some type of special credit that the tax law allows. For example, perhaps the government wants the companies to invest in pollution control devices. So maybe they'll give a special tax credit for that, that the company will get to deduct at the time that they buy the asset. Or maybe there's a special credit for solar energy, or wind energy that if a company invested in those things they would get a special credit. But generally, absent some type of special credit like that, there's no immediate tax benefit associated with an expenditure which is going to be capitalized. So, for example, let's suppose that you bought a machine for $1 million. Well there's no write off, because that's going to go on the books as an asset. The write off will occur as you use the machine via depreciation in subsequent years. So when you buy that machine, the after tax cash outflow is a million dollars because you did not get a tax break at the time that you bought the machine. So those are capitalized costs. Another component of the initial investment are non capitalized costs and these are things that are expensed. So these are things like research and development or training and employee wages. And in this case when you go to calculate what the after tax outlay is, what you do is you take the before tax outlay, and you multiply it by one minus the corporation's tax rate. For example, in the United States, the federal tax rate for most corporations is 35%. In addition, corporations have to pay state and local taxes. Well, let's suppose that between the federal tax rate and the state and local taxes, the corporation is paying a total tax rate of 40%. What would happen then if a company spends a million dollars on research and development? And remember, we're not looking at the project in isolation. The project doesn't file the tax return. The corporation files the tax return. So, if in the first year the project spent a million dollars on research and development, that million dollars would be used by the corporation to reduce the amount of taxes that they would have to pay, assuming that the corporation was profitable. So that million dollar before tax outlay at a tax rate of 40% is only an after tax outlay of $600,000, which is the $1 million multiplied by 1- 0.4. So the point here is that when you have non capitalized costs that are expensed, like research and development, employee wages, training, things like that, the after tax outlay is going to be equal to the before tax outlay multiplied by one minus the corporate tax rate. Another component of the initial investment is working capital. Now the definition of working capital is simply current assets minus current liabilities. But for many projects the working capital investments usually entail increases in inventory, increases in accounts receivable, and from that you would take into consideration any increases in accounts payable. So what would be in a common initial investment? Let's suppose we were going to produce a product that we were going to sell, and we had never produced it before. Well, before we went to market we would normally want to build up our inventory of that product so when customers called and wanted the product we would be able to ship it to them immediately. Now that inventory buildup requires a cash outflow. So, if for example before we actually even started to sell the product to customers, we thought we needed to inventory a million dollars worth of that product. That would be an increase in our inventory of a million dollars and that would be a cash outflow. Now it's conceivable that part of funding of that inventory would come from our suppliers. Right? Suppliers often give corporations 30 days, 45 days or 60 days to pay. So perhaps when our inventory went up by a million dollars, our accounts payable went up by $300,000. In that case, the cash outlay would only be $700,000. The inventory went up by $1 million but it was partially funded by an increase of accounts payable of 300,000 and so the cash outflow associated with that inventory build up would only be $700,000. Accounts receivable, which is amounts that customers owe us when they've bought a product from us and haven't paid for it immediately. That also requires a cash outflow, but that's more likely to take place in the operating phase once we're actually selling the product. Another thing to note about working capital increases or investments in working capital is there's no tax benefit associated with that. So if you have a situation where the initial investment requires a working capital investment of $1 million. That's $1 million after taxes. So you would take that into consideration in determining your total initial investment. So again we have three parts of that initial investment, we have the capitalized costs the non capitalized costs and the working capital.