Hi. I'm going to quickly repeat the year that we did with the numbers that we just did. Please, like always, make your notes. You have the video available, make your own notes. Make the way you would like them. Let's get started. The revenues were five million positive. The costs of goods sold, I believe, were two million. If I change some number, don't mind. This was about 0.5 million. Key difference between lines 2 and 3, one tend to be lumpy and need to be figured out for the specific project. Then, minus one million. This should always question. It's a fake created number trying to measure something real. 5 minus 2 1/2 plus 1.5 million. Still, you are subtracting one million because it saves you taxes. If the taxes are 1/3, remember 1/3 is the tax rate, this is 0.5 million, you're left with one million, then you add back one million. What is that? Depreciation, which is the main non-cash item that has tax implications, maybe that's the best way to think about. CapEx is zero only because I've assumed that. There are many years in which you don't want to invest in fixed costs. This was negative 0.1 million. Not surprisingly, I'm going to spend some more time on this, but the total for this year was plus 1.9 million. I have said what is 1.9 million? That's the C1 we have assumed we know. One more time, stare at this example, pay attention to it. I'm going to now move on to something that I really want you to focus on. I know this is the last part of today's video but you've always the time to take deep breaths and come back to it. What I promised to do is I'm going to pick up next time and highlight issues that I'm now going to talk about. What are the important principles that cut across cash flow estimation? Remember, cash flows will be different for different projects. For example, if it's a service that you're selling, it's a very different way to think about the project than for a product you're thinking, and when you value a company from the outside as an investor, you need to understand this. Regardless of what your goal is, all of this makes sense to learn whether you're inside the company, outside the company, young, trying to understand how the world works, and so on. The good news is, the principles are the same. Estimate all cash flows on an incremental basis. What does incremental mean? Incremental means delta change. Let me just highlight what I mean. Your project is 10 years long, turns out the world operates in the following way. If it's the only project you are considering, you really don't need to worry about incremental that much though you still need to do. But most companies start new projects. What is a company? A collection of projects, that's the way you want to think about it. What is this? You want to figure out your an incremental basis. Do this as much as possible, especially initially. For every project, draw two timelines identical in length. This should be without project and this should be with project. Think of the company. Without the project, what would happen? You would have some C1, C10. The company is making existing product selling and it has some C1, C10. Everybody call this line A without project. You're going to exist without the project. Now, do it with the project, and you'll have a line B with numbers here. Let's call them for the simplicity sake, B1, B10. You can call this actually cash flows A1, A10 if that makes you happier. But remember, A's and B's are just signifying the cash flows of without the project and with the project. What does Delta project mean? Delta project means what? Just think about it. B1 minus A1, B10 minus A10. The value you're creating is not B1, not B10. It's how much B1 and B10 is over and above A1 through A10. If there's one thing I want you to remember about project creation is that is projects are always incremental. It's always good to think about what the world would look like without the project and how the world would look like with the project, because it's the difference. Once you get used to it, you do B1 minus A1 in your head, B10 minus A10 in your head automatically. But this is very important. The reason is, if you do it this way, you never double count. For example, if you spent five million dollars thinking about different projects two years ago, what will happen when you take the difference? It'll cancel. If over here you had five million expense on market survey, five million expense sometime early, what will happen when you take the difference? It'll cancel and that's called sunk costs. Costs that are not important to the future because you already spent them. By imposing them on the project, you are going to hurt the project. Make sense? That's the first principle. Always do things incrementally. I can't emphasize it enough. Very simple practical implication. Do your analysis as if the world doesn't have the project you have in mind and now, with the project. Principle number 2. Do not forget the importance of year 0 and the last year. I want to spend few minutes on this because which year did we choose 1.9 million as? Somewhere in the middle of the year. Remember, what is happening at time 0? Why is time 0 different from other years? Well, the word capital should come to mind. The first aspect of capital is CapEx, which is what? Expenditures on buying machinery and equipment. Let me just make it 10 million, and I'll put a negative number. What is this 10 million? Remember I told you that to start the project, you need to spend a lot of fixed cost of front, and let's assume machinery cost $10 million and that's building machinery, everything lumped into one. What would you like to do with this machinery? You would like to take full tax advantage of it and expense it. The trouble is you can't. The law says and knows that a fixed amount of expenditure on machinery and equip building is going to be used through the year, so you shouldn't expense it out. You have to convert it into some cash flow. The trouble is, how do I convert it? I assumed straight line over 10 years. My depreciation, remember that, was one million per year. That's where the one million is coming from. But this is what will happen at year 0, capital negative 10. Where will the depreciation come in the future? You would ideally like to do what? Deduct all 10 million as depreciation in year 0 because it saves you a lot of taxes right now, and why do you want to save taxes right now? Because of time value of money and compounding. The higher the compound rate, the more the time value of money. The second thing again has capital in it, and that is called working capital. It starts in Year 0. Why? Because remember what is working capital? I'll tell you the important ingredients. Some cash for business plus inventory which is what? You need stuff, inputs to make outputs, and when do you need it? Beforehand. It's working for you and then you sell the product later. So inventory, you need before you are able to sell something. Plus there's another item which is an accounting item called account receivables, also called ARs. Account receivables are what? Things sold on credit. So if you're planning to sell $100 million worth of commodities in Year 1, but half of them will be on credit, and the other opportunities to get all cash, which one would you prefer? All cash because of time value of money, but you'd rather make a sale than not make a sale, so account receivables is things that you've sold on credit, and the person hasn't paid, and accounting puts it in years x, and we'll put it when the cash comes in, minus account payables. Account receivables is on stuff you sell, account payables is what? Stuff you pay for later. If you get some input but pay for later, it's good or bad? It's good news. These are the main working capital ingredients. Working capital is a level, it's coming from your balance sheet. Inventory is a level, cash is a stock, inventory is a stock, account receivable is a stock, account payable. The higher the working capital, the less efficient you are. That's why I gave you the example of Walmart. It tries to make working capital as low as possible. I have the privilege of being at one of the best schools in the world and many years ago, I was in charge of information technology. I didn't have a clue what it was at that time. I said, "Yes, I'll be in charge," because that's what life should be. You should say yes to things you don't know anything about rather than things you know about, because it makes you learn. Anyway, so I had the pleasure of introducing Michael Dell to our whole audience, and remember this was when Dell had just started, and he was really successful with the company. He walked into the auditorium and one of my students' asked him the first question, and what I like about Michael is he didn't give a speech. He said, "Questions. I've nothing much to say upfront. I'll see through the Q&A." So the first question asked to him is, "What business are you in?" I didn't know what to do. I didn't know whether to crawl under a table because I said, "Of all questions, what a question to ask?" Turned out to be a very profound question and this is the truth. I tend to make it more interesting by adding a little spice here and there, but I think the facts are basically true, and he turned around and said, "My business is working capital management, inventory management. I carry much less inventory than my competitors on a net basis, and that puts me ahead before the game has started." What he's trying to say there is that value can be created by managing yourself efficiently, and I don't remember the exact numbers, but inventory is counted in number of days carried. For example, if the competition was carrying 14 days of inventory which is half a month, Dell is carrying one day, and so that's the notion of working capital. The higher it is, the worse you are, and because it's a stock, you measure its changes. I promise to come back to this over again at some point, but let's keep moving on.
