Hi, I'm Rick Lambert. I'm the Miller-Sherrerd Professor of Accounting at the Wharton School. Welcome to Module 4 of our Decision Making and Scenarios course that I'm doing with my colleague, Professor Bob Holthausen. In this module, we're going to try to apply what we've been learning in the prior modules to a new product venture. So we're going to begin by introducing and setting up a spreadsheet that's going to help us do the calculations and redo the calculations as we change our mind as to how we're actually going to have this play out. And then we're going to continue in future lectures talking about the actual forecasting of the future cash flows, the valuation, formulation and evaluation of alternative scenarios, and then going beyond the time horizon that we're going to be laying out. So evaluation of new projects, new ventures, is very much an iterative process. It's not a linear start and then finish. You're going to be going back and forth. You want to translate your project idea into future economic actions, transactions, and events that you think are going to be needed to actually carry out the project. You need to make your best estimate of the outcomes of each of these actions, transactions, and events as well. That's going to help you map those predictions into forecasted financial statements, which is what we're going to use to calculate the net present value, or NPV, of the forecasted cash flows. Then, and this is one of the most important steps, you need to rethink your strategy. Consider alternative courses of action, alternative scenarios, and see how those stack up against your original plan. Forecasting future cash flows. We can't know the future for certain. We're for sure going to be wrong. That doesn't mean that this is a useless exercise. If we plan carefully, we improve our chances for success. We also get to see where things might turn out to be different and make contingency plans for those as well. Many ideas prove to be unprofitable, at least initially, once you start to lay out what has to happen to make them work. But by forcing yourself to lay out the strategy, you can help expose those weaknesses now, as opposed to later, and help identify where you need to rethink your idea and rethink your strategy for execution. So we're going to do this by laying out a spreadsheet. You might want to open up that spreadsheet to follow along. Constructing a spreadsheet in an intelligent fashion that lets you go back and forth between these steps is extremely helpful. So in our spreadsheet we've laid out different sections of it and color-coded those sections so that you can see what is where. Having an assumptions section is a really good idea. This is where you can identify what your assumptions are and change them, and again, the great thing about a spreadsheet is that will automatically filter through through the rest of the calculations. Have a section with intermediate calculations, so I've got that one in green. Then the actual forecasted financial statements, income statement, also a tax return, balance sheet, and ultimately what we're interested in is the cash flow statement. Calculate the NPV and internal rate of return on the project. So we're going to have that one in our Wharton red color. And then, as we build up the spreadsheet, it's important to know that your spreadsheet's going to be wrong, it's going to have mistakes in it, and you're going to have to fix them as you go through. So keep the spreadsheet simple at first, where you kind of know what the answers should be, then, after you've made sure that part works, add in complexity. So our new product venture is going to extend over multiple periods of time. There's going to be an initial investment phase. Okay, that's going to last two periods. An operating phase that's going to last for five more periods. And then finally a termination phase, or a disposal phase, that's eight periods out. Okay, so we're going to have to lay out what the cash flows are for each of those periods, and again, the timing is important. We need a discount rate. We're going to assumed that that's 6%. Remember, that's the opportunity cost of our capital, what's the next best use of our capital if we don't invest in this new product venture. And because these are after tax cash flows, we need a tax rate, so we'll just assume that the tax rate is 40%. Now the investment, or the startup phase, we're going to assume that that lasts two years. But this is something that you need to be thinking about as well. How long till we can get things going so that we can begin producing and selling our product? In our startup phase we're going to have an investment in property, plant, and equipment right at the beginning. So we're going to lay that out in our blue section of the spreadsheet with the assumptions that's going to cost $70,000. We're going to be doing R&D over the first two years, so how much are we going to be spending on those? We need to put that into the spreadsheet as well. We're also going to have marketing and administrative costs over the first two years. And as we'll see, those are actually going to ramp up once we get into the operating phase. In the operating phase, years three through seven, we're going to have production and sales. We're going to have working capital during that period, because some of the payments and some of the collections occur with a lag, okay. The lag, the timing of cash flows, is important when we're thinking about present value, so we need to build that into the spreadsheet. We're going to continue with selling, general, and administrative expenses. And again, those are going to be higher during the period where we're actually selling stuff. We're going to set up our spreadsheet to allow for sales to grow over time, so we're going to come back to that, and also allow for inflation in prices over the period also. Here's our initial assumptions. So I'm not going to go through all of the cells of the spreadsheet, but you can look at the spreadsheet and see where the different assumptions are and how those play into the forecasted financial statements. So we're going to start out with an anticipated sales level of 2,000 units. Initially assume no growth beyond that, but that's something that we're going to change later and see what difference it makes. And again, a variety of assumptions about what our costs are going to be and when we're going to pay for these and when we're going to collect. We'll come back and talk about each of these later on. In our termination, or shutdown, or disposal phase, which we're assuming is eight years out, a couple of things are going to happen. First of all we're going to liquidate our remaining inventory, but at a lower price so the profit margin isn't going to be as high on those sales. Our remaining receivables we're going to collect. The remaining payables we're going to pay. The remaining long-term assets we're going to sell. But we're going to have some other disposal costs as well. So a bunch of one-time things that happen at the very end. Remember that our focus is going to be on the cash inflows and outflows of the new venture itself. We're not looking at how the new venture is financed. The discount rate takes care of that. This represents the opportunity cost of the capital that we're employing in the project, regardless of the source.
