In this lecture, I'm going to go through some things that I want you to keep in mind when you do this analysis. Some of these things we've already talked about and they're refreshers. And there are a couple of additional concepts here that I want to get across to you. So let's remember what it is that we're trying to do when we analyze this cash flows, again the question is how will the after-tax cash flows of the organization change? Its key that you keep in mind that that’s what we're doing or asking how the cash flows are going to change relative to what they would be without the project. So that's the first thing to always keep in mind when you're doing this analysis. Remember that because we're asking the question of how the cash flows of the organization change, we're not analyzing this project in isolation. If you have a project that loses money in the first few years. As long as that company is profitable in paying taxes, the company is going to get a tax benefit because that loss is going to reduce the company's taxable income. And that reduction in the company's taxes associated with taking on this project. That's going to be part of the project's cash flow. So we're going to take into consideration that benefit that the company's going to get from the losses that the project is showing in the first few years. Obviously, again, the company has to be profitable in order to use those losses. So if the company is not profitable there is not going to be any tax benefit if the project has a loss. It's important to remember that this is about forecasting, this is about future cash flows and there's inherent uncertainty about that. So, just because something was a good idea in the past doesn't mean it's a good idea any longer. Just because some product was profitable in the past doesn't mean the product will be profitable in the future. So remember, we're trying to forecast the future. History is a useful guide to the future, but it's not the future. So, we look at past profit margins. We've looked at past sales of light products to try to estimate what we think is going to happen in the future. But it's important to remember that we have to take in a consideration the things that are going to occur in the future that could impact the profitability of this project. So, maybe competition is getting stiffer in our industry, and we're not going to be able to price-product as profitably as we had in the past, or maybe there's some macroeconomic effects taking place in certain parts of the world. Where we do business and that's going to cause our revenues not to be as high for some time period until those macro effects are turned around. So, remember, this is always about forecasting the future, and there's inherent uncertainty associated with that, but that's the nature of what it is we're trying to do. When we forecast the cash flows, we are going to forecast what is often referred to as the investment related cash flows only. Some people refer to this as the free cash flows. But essentially, what these cash flows do is they ignore the cost of financing. So essentially what we're assuming is that we have the cash laying around that we need for the project. And we're going to invest that cash that's just laying around. And sometimes people are confused by that. They say, well wait a minute, what if I borrowed money? And I borrowed you know $100 million at 6%. I have to pay interest. Shouldn't I take into consideration the cash interest that I'm paying? And the answer to that is no, and the reason the answer is no is because where do you think you're taking into consideration the cost of financing? Where you're taking the cost of financing into consideration in the analysis is in the discount rate or the cost of capital that you use. If you also subtract the cost of financing from the cash flows that you're estimating, you're now double counting. You're compensating, you're overcompensating for the cost of financing, because you've included it in the cash flows, and because you've included it in the discount rate. So the way we do this analysis is we take into consideration the financing in the cost of capital. That's where that is done. And then we ignore the cost of financing and the cash flows. So again, think about it as the company has lots of money lying around. It has plenty of money that it needs to invest in this project. And so there's no cost of financing that you're taking into consideration. When you're analyzing how do the cash flows of the organization change on an after tax basis. The other thing that is important to consider and this gets back to the definition of the cash flows again being, how do the cash flows of the organization change? Is we want to take into consideration all of the impacts on the organization. So for example, we might produce a new product. But it may be similar to some other product that we're already selling. And if that occurred it's possible that when we sell that new product will actually cannibalize the sales of the existing products, which means that we're going to reduce the sales of our other products. Since we're estimating how do the cash flows of the organization change, we don't just take into consideration the sales of the new product. We take into consideration the sales of the new product less the cannibalization of the sales of existing products. So remember it's always how do the cash flows of the organization change. It can also be that things are complementary, so if we sell more of this new product maybe we'll sell more services or maybe we'll sell more of some other product, right. And so in that case they could be complementary in introducing this product could actually lead to increases in sales of other things that we do. And again, we would take that into consideration because the question always is, and I know I've said this many times now, but it's how do the cash flows of the organization change. I might add that some incidental effects might be hard to quantify. And what would I suggest you do if that's true? What would I suggest is that you quantify everything that you can. And calculate the net present value based on everything that you can quantify. And then, you weigh that net present value against what you think the cost or benefits are of the non-quantified issues. So, you might find that the net present value of a project is negative, but you think there's some strategic reason for why you should take that project that you're not really able to quantify. Now, the finances, I'm going to help you with that decision, that's a managerial decision but at least if you quantified what you can, you're at the point now where you can say, okay, I know that based upon what I quantified, this project's a negative NPV. And I have this notion that there's some strategic benefit to doing that. I now can weigh those two things and then make a decision as to what I want to do. Don't forget working capital. We've talked about that a lot. Working capital occurs in the initial investment phase or can occur in the initial investment phase. And then in addition, there can be more working capital investments that take place during the operating phase. And it's important to remember that those investments and working capital or cash flow. So when working capital, investments are going up those were cash outflows, when working capital investments are going down those were cash inflows. And you need to take those in the consideration in all aspects of the project, and remember that if a project terminates usually you're going to recover the working capital at the end of the project. So don't forget those working capital investments. So don't forget taxes, we've talked about this a lot, remember what we're analyzing is how the cash flows of the organization change on an after tax basis, right? But what does that mean, that means you have to have some understanding of the company's tax situation. You need to know something about the tax rate they face, you need to know something about what form of depreciation they use, you need to know whether they pay taxes in multiple jurisdictions or not. So, there's a fair amount that you need to know about the company's tax position in order to estimate these. Now it depends on the company and some companies what they ask their managers to do when they propose a project is actually to provide all the information without taking into consideration what the tax implications are. And then somebody who is totally familiar with the corporations tax picture will actually then do the analysis, will add the taxes into the analysis. But if you're going to do that, you need to understand something about the company's tax picture. So again, remember the end of this, we want to calculate these cash flows on an after tax basis. Sunk costs, what are sunk costs? Well, sunk costs are past or irreversible outflows. So for example, I spent $100 million a year ago, or over the last five years. That's gone. I can't get that back. That $100 million is not relevant for any decision I'm going to make today. What's relevant, of course, is what I learned from spending that $100 million. So, suppose I spent $100 million developing a new product over the last few years. But I still haven't finished developing that product yet. And are now at a point where I wanted to decide whether I should continue development of that product or not. And let's suppose that the company or estimates that it's going to cost another $50 million to finish development, so what am I doing now? I'm deciding whether to spend an additional $50 million to develop the product. Do I want to factor the $100 million into this decision? Does that have any relevance now? Should my NPV analysis of the decision of whether to continue to develop this product include the $100 million? The answer is no. The $100 million is a sunk cost, and it's irrelevant now for deciding whether to proceed with development. What's relevant is, how much more do I have to spend to develop the product and then what's the net present value of the cash flows that I'm going to get once it's developed? That what’s relevant. The sunk costs are not relevant. So remember that whenever you're in the decision point. What you've spent in the past is irrelevant, what matter is what's the net present value of everything that's in front of you. How much more development cost there are? And what are the benefits once I have development completed? Opportunity cost, well, the definition is that economist will give you of an opportunity cost is, what the value of that resource in it's next most highly valued uses. Does opportunity cost ever come into factoring in a net present value decision? The answer is yes. So here's a simple example, let's suppose you had a company that was contemplating building a manufacturing facility on a piece of land that the company already owns. So, let's suppose that five years ago, the company bought this piece of land, and it cost them $10,000. But suppose that the market value of that land is now $100,000. You're doing an NVP of whether to build the manufacturing facility. Do you want to charge this project, the $10,000 that the land originally cost? Or do you want to charge the project $100,000 which is the market value of the land? The answer is you want to charge the manufacturing facility $100,000 in your NPV analysis, and the reason is you've already made the $90,000, the company's made the $90,000, the value of the land is already gone up. If you only charge the project $10,000, you're saying that the $90,000 that you made is due to the fact that you're putting a manufacturing facility on that. But that's not right. You've already made the 90,000. If the company wants to they can turn around and they can sell the land right away for $100,000 because that's its market value. So you would charge the project, the opportunity cost of the land, which is what its fair market value is, even though they bought the land for less than that five years ago. When we do this analysis, as I've said, forecasts of the future are uncertain. And when we do our base case what we really want to do is we want to calculate what the expected values of the cash flows are. And one of the ways that we will typically do that is we'll develop a series of scenarios, a base case, an upside case, a downside case for example, and we'll weigh those different cases probabilistically to get some sense of what we think the expected value is. We'll also get some idea of what the variation in the net present value is based upon the upside and the downside associated with this project. And we're going to talk more about scenario analysis in the third and the fourth module. Another thing that we'll do is we'll do sensitivity analysis will perform sensitivity to differences in our estimates of the future cash flows, maybe because of differences in revenue growth rate or differences in costs. We'll look at sensitivity with respect to perhaps estimates of the discount rate or perhaps we'll look at sensitivity to the timing of a project, how long it would take us to get a product to market. Or, once we have it to market, how long we think the product will be marketable. Will it be marketable for five years, or ten years? So, we'll do sensitivity analysis. And, one of the reasons we do sensitivity analysis, it allows us to see what the key drivers of value are, right? What are the assumptions that really matter for this particular project? Maybe, what you'll find out for example is, if you get the product to market in a year which will be ahead of what you think the competition will do, you think you'll capture more market share, and that will be really important for determining whether or not this project has a high net present value or not. But if for example, it took you three years, maybe you don't capture nearly as much market share because now the competition is already in the market. And now the project doesn't have nearly as high of net present value or maybe even has a negative net present value if that happens. That sensitivity analysis is important for a couple reasons. The first reason it's important is because what you now do is you go back and solidify your assumption about when you're going to be able to get to market. So you go back to your people and say, are we really going to be able to get this to market in a year because we know that that's going to be crucial in terms of what the net present value of this project is going to be. And your people go away and they work and they come back, and they say yeah, we're sure we can get to market in a year, and so what you've now done is, you've solidified that. And you now know more than you did before, you're more certain about your ability to get to market within a year. And then, normally what you would do is the person who is advancing this, you would hold that person responsible for getting to market within that year, for managing the project appropriately so that, that happens. So, sensitivity analysis is important because it tells us where to solidify our information and also how we want to manage projects. So let's rehash where we've been. In these first two modules, we've discussed how to calculate present values. And we've talked about why calculating present values is the relevant criteria for evaluating projects, and what we learned, of course, was that net present values really tell us about value creation. And we think that that is the objective function of organizations is to create value. We've also spent a lot of time talking about how to model the change in the companies after tax cash flows associated with the project. And that really is the key thing that one has to do in project evaluation, is making those forecasts of how the cash flows of the organization are going to change on an after tax basis, so we've been very specific about what those cash flows are and how we forecast those. In the next two modules, Rick's going to talk about how to model a project's cash flows using basic financial statements. And then he's going to give you a very detailed example of a new product venture, complete with evaluation, complete with alternative scenarios, that's really going to build on all the things that we've talked about here. Thanks for joining me, and I hope you've found this useful and informative. Thank you.
