 Well, hello everyone, sorry about the little bit of a late start here But welcome back to our unit three discussion of MBA 601 financial management As always we tell you we're doing these live every Thursday and it's part of a video series If you have any questions feel free to leave them in the chat or if you're watching lady You can put them in the comments below and we'll try and get to them next time but I'm just gonna go ahead and Pass it over right now to dr. Lou piercele to get us started and I'll be back if you guys have any questions in the chat great, thanks Michael and Welcome back to our series on financial management again. Apologize for the delay, but we're gonna have to blame me for that not Michael I do finance not technology So we're gonna look at unit three in our financial management course and as always I want to at least go back and reference the Course learning objectives we have and so for for this unit in particular one that we've seen in the previous Lectures, and that was the ability to apply the results of financial analysis to a decision-making process And by now I'm hoping you're getting a sense that We we actually use the analysis we do which can be rather substantial and providing a foundation for making sound decisions for our business and The second second learning objective that is very appropriate for today is the ability to calculate the time value of money Or TBM and apply those results And so we're gonna have a little bit of discussion on this concept of what is the impact of time on money? Now as I have mentioned before this course is laid out into seven units We've completed a review of units one and two and this is unit three financial management And there are four more units in this course to go Now the learning objectives for look for unit three are Basic ones in terms of understanding the impact of money on investments calculating the value of a dollar today As well as sometime in the future Being able to calculate the internal rate of return for an investment Obviously every investment we make there's some expectation of return We want to be able to review and analyze it before making the investment and explaining how the time value of money impacts investment decisions As you know in business many times our investments money we invest today will be some expected return Over some years in the future. How do we account for that and take that into Take it into account when we're considering these investment opportunities Now in unit three There are a number of topics. We're gonna touch base on today We're gonna go back and reference the capital budget again. It's the starting point for investment decisions We'll talk about ways that we evaluate investments the rate of return We'll dig in a little bit on present and future values What the payback period is hurdle rates Discounted cash flows one of my personal favorites and the net present value and internal rate of return All calculations that we use when considering investments Now before I go into the material Just want to make a quick check and see if there were any questions from the last presentation We had last week or any questions before I get started today I Have not seen any questions right at this time But again, everyone if you have any questions feel free to leave them in the chat and we'll get to them Great So let's get right into the discussion and I'll preface this by saying look We're talking today about investment decisions and how to how to evaluate those how does management look at these Now, I mean every business is going to be looking to make investments at some point in time You launched a product. It's it's doing very well. You think you could expand your market share To do that you're going to need to increase production. So you're looking at the addition of some new equipment Anytime we're looking to invest money We're looking supposedly to create more value in the business and create ongoing Value for our investors and shareholders So now what we want to talk about is being faced with some investment decisions What are some of the things that management might sit back and do to help in the analysis? They answer a simple question. Should I or should I not go ahead and invest this money? now every business has resources that they're going to allocate we Early on we talked about one of the roles of management being being responsible for the allocation of appropriate resources To both sustain the business that you have as well as position the business for growth Now we're going to focus on two primary resources that that every business has What is time in the other's money? Money obviously is concerned with your access to capital What is the liquidity of the firm? What kind of capital do you have available to you one that I think is maybe even more important than money in my experience has been time money I can Re-earn I can Find ways to provide more capital, but once I've wasted time. It's gone. I can't get that time back So when we talk about time we're talking There's time to actually make an implementation of a project to launch an initiative What's the amount of time before the firm starts to see a return? And so we're going to consider and think about these things in the decision-making process for investments Now the other thing is we're going to talk about the capital budget because when we talk about making investments for business Typically, that's part of the capital budget Now I can recall in my years of business excuse me Every year one of the major Assignments that we we worked on was the development of the capital budget All right, and the capital budget think about as opposed to an operating budget. We're typically talking about identifying Capital that we have that we're going to use to make investments for the future They tend to be Expensive they tend to consume a larger amount of money And they're going to be there for some amount of time So we try to plan in advance because remember we have to try and ensure that there is capital available For if and when we're going to make an appropriate decision to invest for the firm Now a couple of terms that we should just be aware of when we're talking about capital and the capital budget What is cash flows? Cash flows is just that we're going to talk about cash here We're not talking about money tied up an inventory or property We're talking about cash and cash flows is simply a recognition of at every point in time for every month Every quarter every year cash comes in and cash goes out One of the key things is is our cash flow positive Meaning that more is coming in than going out and during the course of a year We can have times where it fluctuates Where we build up some positive cash flow and then there may be a period Maybe our product is seasonal and there's a period where sales are down and we have a negative cash flow The key here is that we forecast it. We know what it is and we plan for it We're going to spend some time on the Acquisition proposal, which is basically what are you going to do when you consider the purchase of a piece of plant or equipment? We're going to review not only the cost of the of the piece of equipment, but also what additional cost will the firm incur What's the useful life or the expected lifespan of the equipment or the building we're buying at the end of its useful life Is there any potential for salvage value? Depreciation is an accounting function We know that we have depreciation and the income statement and on the balance sheet And what is it depreciation represents how much of an asset we are using up as we go forward in time Sunk cost which is always one that's been Not the easiest to understand and that's that we're not going to consider for our project Money that we already spent So two years ago we invested in a new machine We're not going to consider that cost as we look at a proposal before us now to look at a new Technologically advanced piece of equipment. Those are sunk costs. They've already been accounted for in our planning and address So there we're leaving those in the past One that is very important to understand is basically the cost of capital And you're gonna see how we're going to use that as we go forward and determining some of the evaluations on the value of a project And the cost of capital simply says what is it cost the company to use the debt and equity that they're going to invest in a project? There is a cost involved and so for that we typically use the weighted average cost of capital lovingly referred to as WAC This is an extremely common method of determining what the average cost of capital is to the firm Why average because if you consider the basic capital plan That plan is made up of two sources of funds One is debt financing and one is equity financing each one of those carries a cost and We also have a decision to make and that's how much debt and how much equity should go into the capital plan So let's just take a quick look at at what that capital plan might look like We're putting together a capital plan here. We've determined that we're going to need 5.5 million dollars for an investment project that we have on on the table We've decided that we will get 2.5 million in debt We're going to get from a lender and we have three million dollars that we're going to use from equity that exists in the firm Now the cost of each of these is important the cost of that is fairly easy to know It's what's the interest payment going to be if I borrow that 2.5 million dollars from a bank They're going to tell me what the interest payments are so we'll assume that the interest is 6.2% The more difficult cost to determine is the cost of equity and That's because think about what equity is equity is the amount of money that Owners investors shareholders have in the firm now they have an expectation of return They may that money available to you to make decisions make investments that will generate a return for them But how much of a return do they want? Now there's lots of ways to go through calculating and evaluating the cost of equity I'm going to give you a very simple approach right now And that's that if you look out at the market at any given point in time Assuming an investor could go out and invest in the average portfolio of the market today. What's that return look like? if the return is Let's say it is 9% Then the least expected return that that investor is going to be looking for is 9% Meaning they're not going to be really happy if you're investing your money and earning 4% All right, so we'll establish the cost of debt and the cost of equity Now there is a mix here between debt and equity So we'll determine what the weight is or what the debt to equity ratio is and that's simply out of the 5.5 million The 2.5 million of debt is 45% And the equity is 55% of that capital plan So now I can figure out what the weighted cost is the weighted average cost of capital is the 45% times 6.2 for debt and that's going to give us a 2.8 percent cost and Inequity it's 4.9. So our weighted average cost of capital is 7.7 percent That is the least that is the minimum amount that I would be willing to invest in a project If it's going to earn less than 7.7 percent There should be a really really good reason why you want to proceed because you're not necessarily even going to cover the the cost of capital Now one note that I'll point out here is a major decision That the executives and finance folks in the business will make is the capital structure And so we're always looking for the optimal capital structure And what it what that is is simply the ratio of debt to equity that results in the lowest cost of capital So in an Excel spreadsheet, I could actually sit here and lay out different weights of debt and equity Do the average weighted cost and what I'm going to do is determine the The amount of debt and equity that I will use based on that which results in the lowest total cost of capital Okay now having said that before we get into much in more into investing Let's talk about a few basic rules that as a as a business executive. I was very cognizant of One money that's not allocated for any business purpose should be invested All right, if you have money in the account Excuse me And it's sitting there. I don't have a current investment opportunity in front of me We don't want the money to sit there We want to recognize the fact that we have to a responsibility to try and maximize the return So we'll look for a short-term investment For that money to we want to ensure that any expected returns on investments We may are going to meet or exceed the target return and Again to keep it simple. We'll assume that our target return is at least the weighted average cost of capital and Then third given a choice among investments Assuming I can't invest in all of them I have to pick one then you select the one that has the greatest rate of return over our target rate Okay, very simple very basic but well worth Remembering and bringing into your decision-making process Now I've talked a lot about rate of return We'll talk about just a couple of a simple rate of return here is where you simply take the Revenues generated we say incremental because of the revenues that are result from the project directly from your investment. Okay Minus any expenses that we incurred again as a result of this project Divide that by the investment and you've got a simple accounting rate of return Now what that doesn't allow for is the time value of money, which we're going to talk about in a bit There's an expected rate of return and again that expected rate of return is as a management team as an owner You have some expectation of what you're looking To get based on the money that you're investing. What kind of rate of return are you going to get? As a management team, I might be looking at making two or three investments The expected rate of return simply takes a weighted average of all the potential outcomes of the three things I'm going to invest in again assume they have different rates of return So what's the expected rate of return by investing in three projects and in this we're also going to consider probability and risk? Probability that this investment will actually return a cash flow that we forecasted and what's the risk of the investment? There is no risk-free investment. I wish there were I haven't found one yet, and it's been many many years that I've been looking So we have to identify risks and we assign probabilities. What's the probability of certain outcomes? We can put those all into a formula. We can weigh those and get an expected rate of return One other point I'll mention here when we talk about probability Remember that from a financial standpoint we talk about the risk of an investment We're not talking about the potential for losing it all which we could Financially we're assuming we've done lots of analysis lots of research lots of review So the risk is what is the probability that the actual return will be less than the expected return? All right, and we wanted we had an expected return of 10 percent What's the probability that it will be less than 10 percent? So we're gonna we're gonna constantly look at probability and risk and last you'll hear you'll hear Businesses talk about the hurdle rate when they're considering investments And again the hurdle rate is simply the minimum rate of return that I am willing to to accept an investment I'll establish a hurdle rate for my firm which might be 11 percent Having said that we won't I won't entertain any investments that are showing a potential return That's less than 11 percent what's that 11 percent based on it's based on expectations of return shareholder expectations the cost of capital And risk the higher the risk the greater the the hurdle rate is for a project. Okay now another item to consider in this is Thinking about the cost I'd like to make it simple say we just chart the cost, but there's more than one cost involved here So we need to we need to categorize the cost and valve We want to identify only relevant cost when we're looking at an investment a relevant cost is simply Any cost that is going to be occurred specifically because I'm making this investment I'm buying a new piece of equipment. There's going to be Transportation costs to get the equipment to the plant. There's going to be electrical costs to do some rewiring care any cost Directly related to the investment is relevant and should be included in our analysis Well, think about the cost of cannibalization That means that if I'm putting in a new equipment or launching a new line What is the potential that the new products will take away from the existing product line? Well, I experienced a loss and what we're already having if I am I need to identify that and consider the cost It's a one of the costs that will come with making the new investment Opportunity cost you hopefully remember from probably your first course in economics economics 101 An opportunity cost simply says what's the cost if you choose this investment over another one If I can only take one or the other am I giving something up by choosing one and that too And we've already talked about some costs recognizing excuse me that they can't be considered now Here's the big part of the beginning of our show today, and that's a discussion of the time value of money and Simply put in pierce all's world that is that a dollar in your hand today is worth more than a dollar You're gonna receive a year from today Why is that? It's because if the money is in your hand today, you can invest it and earn interest A friend comes to you and says look if you loan me $500 today, I'll return it to you in three months Okay, it's a friend. You loaned $500 three months. You've got $500 You've lost three months of earning potential on that money So that's the way business looks at this and this is one of the basic premises of the time value of money We're going to consider what what the value of money is today And what it is in the future So let's just look at future and present values of an investment The future value is what is your money going to be worth at some point in the future now We're going to start with a simple one our simple investment right now is going to be i'm going to put some money into a savings account Why because I don't want to keep it buried in my backyard So I'm going to take that money. I'm going to open up a savings account and I'm going to earn some interest And so we typically talk about compounding interest Each year that my money is in the account. I have the principal I've added interest to it in year two I've got interest and now on the original principal plus the interest earned and so as I go forward I can determine what the uh what the future value of my investment is depending on how long I'll keep that in the savings account Having said that we'll look at the present value Now present value we're we're is a is a way of considering if I know that I'm going to get that $500 three months from today Knowing that I'm losing Three months of the potential of earning interest. What is that actually worth today? And this is where we talk about discounting future values And we're going to discount by the the rate of interest that we could earn Now I've included here two simple formulas One for future value and all it basically says is the future value of a sum of money To be received x number and number of years in the future Is going to equal the present value what that investment is today times one plus the rate of interest Or the expected rate of return Raised to the number of periods two years three years five years That will give you the future value of your investment. That's one way to think about compounding interest If I take that future value of money, and I want to know its value today I can solve for the present value and note that the formula for present value is the inverse For those of you that are into math of the future value formula It's future value divided by One plus the expected rate of return raised to the number of periods of the investment So going either way forward or backwards we can make a determination on the value of money Now This is the basis of time value of money It's not that complicated But we can't ignore it because when we're talking about millions of dollars of investments these have major impacts And we want to be able to think about those and consider them So let's look and how we use some of this this data and Evaluating investments And what I want to do is I'm going to start with some really simple A simple process first and we'll go get more complicated as as we go forward So the first simple quick evaluation you can do on an investment is to calculate the payback period In other words, you're going to take a certain amount of money You're going to make this investment you have any expectation of getting Some cash flow. So some amount of money each year for some number of years in the in the future How long is it going to take you to get your money back? So not considering future values or interest rates or expected rates of return Just a simple back of the envelope calculation of payback If our investment was six million dollars And we're expecting to generate 2.5 million dollars a year Then you'll earn your six million dollars back in 2.4 years payback period Now the advantage is that it's a quick way to get a get a view to how long This investment may have to be out there if you to get the money back We recognize that the sooner you get your money back the better off you are why Because you can invest in something else The other thing is that the longer that an investment project goes The risk increases that something will go wrong Not necessarily with your project, but it could be in the economy It could be in market demand consumer preference Competitive actions So we we recognize that the farther we go out in our investment the greater the risks that are going to be incurred Now the disadvantage of the payback period is that it doesn't consider anything with time value of money So we're not talking about the impact of interest that could have been earned that we've lost or the like So obviously we're going to have to get a little bit more sophisticated going forward Remember that I mentioned cash flows When we're talking about making an investment There is some expectation that you're doing it because you're going to create more revenue Typically that value is an increased sales You're going to bring in new equipment, new technology that will reduce errors Improve the quality of the product Produce product quicker, reduce costs, and perhaps increase sales So there's some expectation That you're going to get a positive cash impact from the investment That means that we must forecast cash flows So if this is going to be a five-year project, then for our five years I need to forecast each year what the cash inflow will be What's the expected revenue that's going to be generated because you made this investment each year? And What is the cash outflows? There's going to be expenses associated. What are the costs? Associated each year with this project And the balance will be the same And the balance will be cash flow whether it's positive or negative We're going to forecast cash flow each year. All right Absolutely important criteria for evaluating any decision to make an investment going forward Now before we jump in and look to make this a tad more confusing Let me just stop again and see if there are any burning questions out there We are not I'm not seeing any questions in the chat right now But uh, yeah, that was a lot. So obviously if people have Any questions going forward again leaving in the chat anytime you don't have to specifically wait for the Question block, but if you're if you're watching later, which I know people do Feel free to leave a comment below and we'll get to it Next time when we can Great and as Michael said look if you do have a question and they come up when you're reviewing this again Which hopefully you will there's a lot of material that remember this is a review This is a review of a course that has a ton of material in it Obviously we're I'm making a short presentation here on something that in my experience. I spent years Working on and years actually learning how to how to make good decisions with this information But if you do leave questions, we will attempt to get back and answer those questions. So feel free to do so um now now we're gonna Try and make this just a a tad more complex But because the the decisions we're making are so important We we really want to make sure we understand the potential impact to our business So what we're going to do is I'm going to talk about the idea of net present value or npv Now, I'm guessing if you've taken any introductory finance course at all you've heard about net present value Um, so let's let's try to understand exactly what it means and simply put Uh, when you're making an investment, I decide today that I'm going to invest Three million dollars in a project. We're going to put in some new equipment to expand our production capability That investment is today's dollars right because it's in my account. I've got that three million dollars Now I haven't done anything with it yet. It's sitting there. It's in my capital budget Waiting for me to decide to invest it um When I do evaluate a project and I say well, look I if we make this investment I expect that we're going to get a a return And I expect that we're going to get a return that is equal toward greater than that hurdle rate. I mentioned Um, but that return is going to come in the future And so I know we're now talking about two things I've got the investment which is present value And I've got the future returns which are future value I can't compare two unlike items present and future. So how do I do an evaluation that makes sense? I'm glad you asked that question. That's the basis of that present value So what we're going to do is we're going to convert the future values the present values so that we can we can compare Now the net present value calculation is not complicated That simply says let's calculate the present value of the future cash flows And remember when I first mentioned present value, I said that we're going to be talking about discounting Right, so to take the to discount those future values each year By the interest that I could have made if I had put the money someplace else This is the concept of discounted cash flow Which sounds like it's terribly complicated. It's not one of the one of the hardest parts of Preparing to do a net present value isn't the formula. It's the forecast of cash flows Because remember as in any forecast You're sitting there today You've got the best minds in your in your company around you gave they they've made a proposal that you need to make this investment in new plant equipment because You will generate more revenue But now we're asking them to forecast How much revenue is going to come over the next number of years? And what will those costs be? Now remember a forecast is a forecast. It's not a fact I can use excel spreadsheets and and do all kinds of mathematical calculations. It's still a forecast Those forecasts are only as good as the information that goes in And the decisions that you make based on what your current knowledge of the market is Remember we talked before about I can look back and say what our trend was what we did historically And I also mentioned that historical data is not necessarily a predictor of the future So now I have to look at the market competition the economy Uh consumer demand and forecast what I think the cash flow will be in the future Once I have that I can discount that those future cash flows And determine the present value of those flows I know what the present value of the investment is So I can subtract that and the end result is the net of those two It's the net present value the difference between the cash that's going to come in And the investment that I'm making now Having said that let me give you some very basic rules that apply to net present value Let's suppose we've gone through the Analysis the forecasting the planning you've done the appropriate discounting And you've determined a value the net present value. What does that tell us? Well, the rules of net present value say that if the net present value is a positive value Make the investment Suppose the net present value is fine What does that actually mean? And let me go back to the slide here if the net present value Excuse me is positive It means that the return on this investment has covered the cost of the investment debt equity and exceeded the expected rate of return Right because the expected rate of return is what you used to discount those future cash flows So a positive number is positive. It's good You you're covering the investment and you're exceeding the expected rate of return go ahead and make the investment Now if the NPV is I should say the higher the NPV obviously the better the investment So if you have three potential investments before you you've calculated the three NPVs They're all positive, but you can only afford to go back to my earlier rule. Which ones the ones that have the higher return The higher values represent Creating more wealth for the firm than less Now if the NPV has a value of zero Now you've got to make one of those management decisions This is a management call What this says is that this investment has covered the cost of the investment It's covered your cost of capital But it's not producing any additional positive Income or creating any additional positive wealth going forward So do you or do you not make the investment? It depends If the investment will result in something that May have other implications for the firm competitive positioning Karate quality or the like which can't be quantified into additional positive cash flows You may decide to go ahead. The good news is you're not losing But it's not creating the additional wealth above your expected return Okay Now if the NPV is a negative value, here's the rule. Don't do it Why because if it's negative it means that the return on this on this project doesn't cover the cost of capital Or your hurdle rate doesn't cover your expected rate of return So we're not going to do it now The net present value is probably one of the most commonly used Uh analyses when considering an investment opportunity It is used all the time. It's worth Taking some time and really thinking about it As I mentioned before there is a lot of material in the course on this But in addition to that there is a ton of material online In all kinds of reports analysis And documents that you can review and evaluate on the topic of net present failure If you are in business looking to get into business And are going to have any interest at all in participating in investment decisions Then you need to understand this concept of time value of money and net present value Now one thing about the net present value is it does give us a number It does tell us that there it is if it's positive that there is an increase in wealth but one thing that Owners and executives will be interested in as well as shareholders is but what is that as a what's the rate of return on that And we don't get that from the net present value So yes, we're going to do one more calculation here and that calculation is we want to look at what is the internal rate of return or irr now The internal rate of return Is simply uh taking that same the same values from net present value But we want to look at is there a way for me to determine what the percent of return is And good news there is If we were able to set up a formula where we um where we set the npv at zero And do some additional extrapolations and calculations we can come up with the internal rate of return Now while you can do this mathematically with a formula, I will tell you it gets to be a tad complicated um, it is much easier To use a financial calculator for this and i'm going to touch base on that just before we close out this presentation But let's assume that there are two projects being considered Project one has an internal rate of return of 17.5 Project two has an internal rate of 20.1 And i'm guessing that at this point you know exactly what the rule is If we can only invest in one of these which one the one that has the greater internal rate of return So let's suppose that we're looking at our hurdle rate Uh for our business was we had set it at 18 percent Well to make it fair let's assume there for project i'm let's set it at 17 percent We know that project one is going to return 17.5. It meets and exceeds our expectation 20 percent is more than our our hurdle rate So if I can only invest in one which one the one that has an internal rate of 20.1 percent Now this will have been a lot of information a lot of numbers. There's some very um Very serious concepts here in terms of financial management and business planning. So again Any of these topics that you're interested in I suggest that you you take some time and and dig a little bit deeper And evaluate exactly what it is. We're talking about and I want to leave with one final note here I mentioned a financial calculator if anybody has been involved in financial In a financial position is dealing with numbers Then you you probably already Understand the importance or the value of having a financial calculator This is a picture of the one that I've used for probably 20 years now. It's a hula packard 10 b2 financial calculator Note that uh, it serves as a regular calculator. There's math functions. You can add and subtract numbers But for financial analysis Note that across the two the top here We have the ability to by inserting a few numbers we can calculate the future value The present value The internal rate of return um The markup the percentage and so these are extremely valuable if you are going to do more than One financial calculation in the course of doing business if you're going to be doing any analysis at all It's well worth looking at something like this They're not expensive and the good news is that there are lots of tutorials available Online including lots of videos available on youtube on how to use a financial calculator so with that Uh next week, uh, we're going to talk about unit four and we're going to get in more to this idea of risk and return And remember that every project has risk The greater the risk The greater the expectation of return so we'll dig into that a little bit and uh and go forward with that discussion So again at this point I'll uh stop and see if anybody has any questions and turn it back. Michael Um, yeah, well, I don't see any questions in the chat right now But I'll give everyone a second while we wrap up and I'll ask my own question Are people people are still using ti's to to do to do financial calculations still I would have thought if you phone apps at this point, I haven't done it in a long time Okay, well, let me say for my generation. Yes, it's still ti But yes, there are also you can do them on your phone And there's also a tremendous application here for things like excel spreadsheets Which have all of these formulas and when you're doing financial analysis, you normally have a spreadsheet It's just as easy to build the formulas right in so I still use the handheld calculator. Thank you It wasn't trying to put you on the spot. Um, all right. Um, well, I'm not seeing any uh questions coming in in the chat right now So let me just remind everyone if you're watching this later, you can leave a comment This is of course part of the larger video series. So you should go back Catch up on that. These are of course just supplemental to the course itself But again, I'd like to thank everyone for joining us I'd like to thank dr. Pierce all for taking us through all of this and we will see everybody here at the Same financial time same financial youtube page Thanks everybody