These are the two items at time zero, capEX and working capital, remember, both coming from your balance sheet and take changes. Good, let's go to principle number 3. Accounting issues are very important and I've talked about this, let me just again tell you one more time. The main accounting issue to worry about sorry, the main accounting issue to worry about is what? Depreciation. Why? Because it's made up. And similar, non-cash items. Why? Because you worry about them only for tax reasons, after that you got to add or subtract if you subtracted or added. The second issue to worry about is working capital. And remember, working capital is coming from again, two firms capEx and working capital. I apologize for that slip up I meant total capital broken up into two parts. CapEx and working capital come from balance sheet, and remember, therefore you have to think about changes, okay? Think about accounting a lot more than this, I have emphasized earlier that this is the one area where this course couldn't possibly do justice. And the reason is you have to spend as much time you have understanding accounting as you have done on this course, if you want to dig deeper into understanding the details. Having said that, I'm exposing you enough that you'll be able to understand what's going on. And do more accounting based on what your needs are, okay? Okay, let's keep going with this. We have done three principles, I have a couple more to go. Important principle, very important, do not mix financing with operations. And I think I tried to emphasize this earlier that while you're doing project analysis, stay here. While you're doing project analysis, please stay on the asset side because these assets give you cash flows and then we later worry about what the discount rate is. But the value is generated on the asset side of the balance sheet, and this is extremely important. So think about it this way. If you start thinking about financing while doing project analysis, you're worrying about an issue that doesn't add value. What adds value is whether your idea is good or not, and you'll see later that this guy over here will reflect your financing. So you're already going to take it into account when you're going to discounted cash flows, so when you do project analysis, stay out of financing. So there is a famous song, can't touch this, it's by MC Hammer and just Google MC Hammer. Every time your hand goes in this direction and starts worrying about financing, just say, can't touch this. This is the one time I want you to be in my class physically because I really think things like that make you remember things more than my saying, necessarily only conceptual argument. But basically, when you're doing project analysis, don't worry about financing. And the reason is two, one, money is not generated by financing, money is generated by your ideas. Second, when you're discounting a cash flow, you're taking financing into account. I'll give you a third one, which will help. Your ideas generates cash flows and financing just divides up the cash flow. So, for example, if you have only equity, only owners, only shares, all the money goes to them. If you have debt and equity we'll see next week, debt gets paid first then equity. So the cash flow, they're shared in financing, they don't create value, okay? Very important, we have one more principle to go. We actually have, sorry, more than one probably, include the effects of inflation, deflation. This is relatively easy, but it's a very common error, what do I mean by that? When you're doing C1, when you're doing. When you're doing C1, C2, and so on, remember, these are your cash flows, right? Remember, underlying this is for revenues, for example, just taking an example, it's price times quantity, period one, period one, price times quantity period two and so on. When you're projecting the prices, please remember inflation, because if you ignore inflation and inflation usually happens or deflation. For example, laptops, do their prices for the same kind of laptop increase or decrease? Decrease over time, so I'm not necessarily meaning inflation, I say inflation or deflation. If you don't take the prices into account, you will be making a big mistake and the reason is when you discount your R has inflation in it without question, except when clarified in a particular context. And it has other stuff which I call real stuff, but inflation is always in the R, so you're going to discount based on inflation. But if you haven't built in inflation, then you have a problem, right? And one last comment about inflation, every item in your accounting statement or a cash flow statement rather has a different inflation. So your revenues may be growing at 10%, but the cost of good sold may be growing at a slower rate or faster rate, why? Because one is a supply input and the other is a demand based output, and they're different animals, right? So the inflation and everything is not constant, so when you do a detailed analysis, always think of inflation and for different things. One last comment, it used to be a very tough thing to do, why? Because there's no computing ability 40 years ago to do even one line item. But now you have prices on everything available, and you do see this analysis based on line items, depending on your business, of course. There's a lot of variability in inflation in different items of your business. You take them into account, if they're similar, then you don't, but you have to think about it. Okay, we're almost done. Do not compare project with unequal lives and this is going to be one of the last items I do. And for today, before I forget to emphasize, I'm going to stick with the ten year project. When we start next time, we'll talk about bonds and stocks and the main difference is bonds have a finite life and stocks have infinite life. So what I'm going to introduce is the notion of what do you do after the ten years of the project? Like I said, that one principle is, worry about starting point, and I emphasized time zero, think about the end point too. And at the end point, if it's ten year project, you wrap things up, sell your inventory, bring it back, we'll talk about it. But if you're going to expect the project last longer than ten years, you worry about something that's called terminal value. What's the value of the project at the end of it. We'll talk about it, I promise, in the context of bonds and stocks, it fits very naturally. Now, unequal life, so let me give you an example and will then promise to stop at that. And I'm going to write some numbers for you, and please bear with me. Suppose you have project A and project B, and I'm going to make it very simple so that you understand, time 0, 1, 2, and 3, okay? So project A looks like this, 20 million negative expense, 2 million, 2 million, and I'll explain in a second. And Project B looks like this 25 million, 1 million, 1 million, 1 million. Why am I calling this project? Because I call everything project. Do you agree the lives are not equal? One is two years long, one is three years long, so what are these projects? This is a classic case of creating value by making your machine choice. Remember, what did I say? You first thing, when you start any project, you have to choose between machines. So supposing you have two alternatives, one machine cost 20 million in year zero and what is two million every year? Take a guess, maintenance and then the machine is done. Machine be cost $25 million, what is this 25 million, what? Where will I get this number from CAPEX. What is one million, maintenance is not working capital, this is maintaining the machine. One million, one million, one million, how many years does this last? Three million, so this is a cost minimization exercise and let's ignore taxes for simplicity, think of this is after tax, okay. Quick question, can you do the present value of the two machines? The answer is yes, if you tell me what the discounted or the interest rate and let's assume for the simplicity that are is 5% [COUGH]. Can you do this exercise? Yeah, I can, very simply, the good news is I just have to do a simple PV analysis. Turns out if I do this the answer, the PV of the first PVA is equal to negative 23.72, PVB is equal to negative 27.72, how did I do this? NPV analysis, remember, these are only costs, so how did I do that? Well, very simple, for A hat did I do? 20 million, do I do the present value of 20? No, then I do present value of two million for one year, two million for two years. If I just add up these numbers, how much do I get 24 million. Why am I getting 23.7 to simply It has to be less than 24 million. Why not buy too much? Because 20 million is a chunk that's not being discounted. And two million at only 5% rate of return. Remember, the 5% discount rate is a low number. Similarly, 25,000,001 million. One million. One million Which machine villages? And this is an exercise I'll ask you to think about. I'll tell you the answer right now, but I'll ask you to think about over the week we'll go through. It will come back to it, I promise. That's where the this is a very important mistake people make in the real world. Which one will they choose? Yeah, without thinking. We think of buying cheaper machines. But here's the fact of life, which you learned the hard way. The cheaper machine is usually also a shorter lived machine. Not always, but usually it's not only more maintenance, it last less so. Can I compare these two? Answer is no. And here's the awesome thing. Finance makes you modify these numbers for the life. One way to do it is what to make everything equal in life. So how maney machines do I buy? I buy keep buying machines so that the lives of the two Horizons are the same, right? So if I do this analysis of the six years, that's one way to do it. One simple answers convert this into an annuity. That is how much is 23.724 year taking into account time, value of money, and this works out to be 12.76 So annuity PMT off a is 12.76 So what is 12.76 If I take 23.72 and spread it over two years but taking time value of money into account, it's 12.76 per year. If I spread this over three years, PMT off B turns out to be 10 0.18 What am I asking her? I'm asking the following question. If I had just 23.23 point 72 for the fact that it lasts only two years, it works out to be more costly per year. If I had just 27.72 for three years. What happens? The per year costs are only 10. So which one really choose? You'll choose machine be Then I'll come back to this and I walked work through how I got these. PMT is next time. But right now I challenge you to think about this problem and try to do all this analysis on your own. The numbers up there for you and you have to next time and some more practice. So final point today. Please take the time toe, understand what's going on in the video and then do your assessment. Every week I force you or require you to do an assessment. I can't force you. You're far away. So I would I would really encourage you to do these problems and then do assessments and try to figure this piece out on your own and figure out why did I say you actually should choose machine Be See you next time. It was fun talking to you again and hope to see you soon. Bye.
