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So, let's spend some time on understanding the intuition. So, we have cash flows, we

Â have very simple cash flows. What were the cash flows? -1000 today, signifying our

Â effort. The cost of what it took to start the project and what was the cash flow

Â next year? 1320. Where do these cash flows come from? And I'll later use the

Â following language. Who do they belong to? Please recognize one thing extremely

Â important and I will keep emphasizing this, but it's very important. Cash flows

Â belong to the project, to your idea. You are responsible as the person generating

Â this idea to come up with the cost and benefits, you know, because if you can't

Â do it, then the idea is not obvious to anybody. So, this is the first step in

Â recognizing what are the cost and benefits of your own idea. Now, it's not easy to

Â do. It involves Accounting, it involves Finance, and so on. So, I'll spend an

Â entire session next time on how do you come up with these. But I must warn you,

Â that's the one part of this class that I cannot spend a lot of time on, because it

Â will require you to do a class at Accounting. Remember, the language that we

Â use is Accounting? We'll use, if you don't understand Accounting, we cannot take

Â business plans and convert them into cash flows. But don't worry, it's not that

Â difficult. I'll introduce you to enough part so that you can do some basic stuff

Â yourself. So, what our cash flow then come from? The most important point is think of

Â them as profits, not revenues, not cost of doing same thing. Profits. Right? What is

Â left in the end. Those what we call cash flows and they are current at various

Â points in time. In this case, 1320 in the future and the cash outflow today is

Â -1000. The key point, however, is it's your ideas signature. It's unique to your

Â idea. So, the idea and cash flows to me are the same thing. Idea and benefit and

Â cost are the same thing because if you can't combine the two, it's, an idea is

Â meaningless. Okay? Now, here's the important point. What is r is our problem?

Â The interest rate. It's ten %. And this is something that's really critical to

Â understand. So, if the cash flows come from what your sense of the idea is, your

Â ability to. Figure out the cash flows, and it obviously ultimately the cash flow also

Â depending on the customer to buy your product or not. But what I'm saying is

Â it's your responsibility to do all the hard work to show what the cash flows and

Â benefits of the idea are. Where does r come from? R is an extremely critical

Â aspect of finance. R captures the opportunity cost of investing in this

Â idea. Opportunity cost is easily said, everybody nods their head when it is said,

Â but it is very tough to understand. And PhD's take tests on opportunity cost,

Â people have been working on the real world for years and they screw up. And the

Â reason is, it's a very easy concept to say, yes I understand it, but it's very

Â tough to actually figure out. So, let me tell you why r is tough. You would

Â imagine, as most of the world does, is that r comes from thin air. In fact, most

Â of the time, I'm really frustrated where people pull r out of thin air and say, you

Â know, it is twenty%. Why? So, here's something very important to understand. R

Â comes from the next best use of even your own investment, leave alone other people's

Â on a similar project. So, think of r as not belonging to your project. R is that

Â return, that is coming from, investing, in say, a competitor. So, imagine you are

Â going on, you've a great idea, but similar ideas usually exist, right? It was the

Â internet boom that threw us off, because we had never seen things like that. But

Â typically, your idea's not brand new. Something similar is going on. So, imagine

Â if you have the money to start your own idea. I think it would behoove you to look

Â at existing people doing the same thing. And if they are getting a better return

Â than you are, it doesn't make sense for you to do it, right? So, it helps society

Â to use r as the return or the possibility of making money in a similar venture with

Â a competitor, that becomes your r. Because when you go to r, you should be thinking

Â like the investor in you or in other people. What will an investor do if you

Â show me your cash flow, cost and benefits, what's the first thing that will strike

Â me? How could I do better? But in the same type of business, because I can't compare

Â businesses that are making rocket engines with selling bananas. And you'll say, why

Â not? Because they are not the same thing. One is much riskier than the other. We'll

Â get to that. Okay? What does the final number mean? So, what was our NPV? Our NPV

Â was what? $200 dollars, right? What is the unit of, unit of measurement? Dollars. It

Â is the measurement of value, in, I am not saying dollars can measure all values.

Â What I am saying is the unit of measurement is the unit used by everybody,

Â right? So, here's the cool thing, you will add $200 or 200 million if you may, If you

Â want to put everything in million, in net value to you and hopefully to society, by

Â this idea, right? So, so, the final number has a very cool number as well. It says,

Â how much value have you created? You've created 200 million worth of value, why?

Â Because you invested a 1000, and you got 1200, you got 1320 but when you discounted

Â it back today, by what the competitor could have done, you are making 200.

Â Should you pursue this idea? What do you think? Answer is yes and the reason is

Â very straightforward. You're creating positive value, right? One caution. One

Â caution. If you do not have the resources to do so, should you not do it? And why am

Â I using this conscience, caution, caution? Is because there could be situations in

Â the world where you have a great idea but don't have the resources. And what comes

Â in to your rescue? Markets. Competitive, fair, not money lenders dressed as banks,

Â whatever. It's fair resources available to you. Why will that happen? Because most of

Â us don't have great ideas, I mean it's okay not to, right? I don't come up with

Â great ideas all the time. It's very tough to come up with great ideas. So, what do

Â we do? And we have mostly savers in society if you ha ve the resources, of

Â course, and we want them to go to the people with the ideas. And the people with

Â the ideas, don't have ideas, great ideas all the time, right? So, at some point,

Â they also want their resources to go elsewhere. So, if the resources are not

Â there, then ideas are not implemented. Therefore, the importance of markets. So,

Â I'm going to assume, if you have a good idea, resources will come, regardless of

Â whether you have the resources or not. That clearly depends on the availability

Â of a market, right? Okay. Net Present Value, the essence. Value is always

Â incremental, and I'am going to emphasize this because this is extremely important,

Â it puts everything together, to what. So, lets get started and let me ask you the

Â following cool thing. Suppose you have a $1,000, and you're going to invest it at

Â times zero. What is the option? The option is clearly, very simple. Your idea is

Â being practiced elsewhere. So the r of ten%, as I said, is what is gotten on,

Â say, a similar or a competitive idea that exists. So, you are investors, say even

Â your dad [laugh], says look, I have a thousand dollars or a million, whatever

Â and I can figure out how much can I make in the market place, the important thing

Â is apples to apples. So, if you set up a banana stall, your dad should be comparing

Â it to a banana stall. If he set up a rocket engine machinery factory, he should

Â compare you to something similar. Because risk, apples versus apples, oranges versus

Â oranges. So, suppose he took this money, and put it in an existing business that

Â was similar. How much would he make? Its very simple, you've got to calculate the

Â future value of a $1,000 one year from now. Don't tell me you can't do it, you

Â can. It is 1100. Do you get it? Take a 1000, you get the 1000 back plus the ten

Â percent return so what is this? This is = P(1+r). This is the first thing we did and

Â what is P? $1,000. Why is it negative and this positive? Because incomes and then

Â you get a gain. So, the $1,000 grows into 1100. This is the existing idea. Somebody

Â is already doing this kind of business. Obviously, sometimes, you have a brand new

Â idea, and it is tough to evaluate and that's why we screw up. [laugh] when new

Â things come because, after all, we are human. So now, what does your idea say?

Â Your idea saying is, give me the thousand. This is the, your alternative. And I'll

Â give you how much? Well, somehow you are so cool, that you're able to generate 1320

Â instead of 1100. Why am I emphasizing this? And the reason is value is not

Â created in absolute amounts. This is extremely important, value is always

Â created in a relative amount. So, look at this. This is the same investment, so I'am

Â not having an investment of 500,000 versus 1,000. But look at what's happening.

Â That's why [inaudible] problem is so simple. How much am I creating? Yes, I am

Â creating 1320 but that's not the right way of figuring out a value. The right way of

Â figuring out a value is how much I have created additional to what already would

Â have existed. So, take 1320 and subtract 1100, how much are you left with? 220.

Â Everybody gets this? I have been able to with my ingenuity, in a very similar

Â business with a similar risk, able to create value of 220. By the way, this is

Â happening all the time. Let me give you a very simple example that we'll come back

Â to, Walmart. Is Walmart doing something that was never done before? Heck no. I

Â mean, not to take anything away from their efforts, they don't sell something that we

Â have never seen before. Walmart is not like Apple, which has created something

Â new that we like. It is selling stuff that we already wanted to buy, right, but in a

Â different way and created value to that process. So you have 220, but when is the

Â 220, which year? Now, look at the beauty of this. Well, if I bring this back today,

Â how much is it? Very simple. 220 divided by 1.1. Why? Because the interest rate is

Â ten%, and I am discounting for one year. How much am I left with 200, which is also

Â what, NPV. This is something that is so important to recognize that the process of

Â discounting that we did, r ight, the process of discounting that we did, takes

Â care of the opportunity cost of capital. Another way to think about it is everybody

Â else was making zero, then everything is green, right? But everything, everybody,

Â else in this example is not making zero, they are making ten%. I hope this was

Â useful and I hope that you remember that net present value is always incremental.

Â And value creation is always incremental because that's how life is. There's no

Â such thing as absolute value. It's always relative value. Okay, let's do another

Â example and then I promise we'll take a little bit of a break after we do the NPV.

Â So, what's the NPV of this? So, we, let's go a little bit faster. Why? Because we

Â can. What's the value of this? -1000. What's the value of the next guy? We

Â already know this, 1320 / 1.1. Remember, ten percent is the discount rate. And

Â note, now that you know how to do present values, I'm going a little bit faster. And

Â we just did this. What is the NPV? Now, this is a little bit tricky and I'll do

Â Excel in a second. How much would you, so this one, how did I get? I took 1320 and

Â divided it by one+r which was 1320 / 1.1, right? And I got 1200. Now, look. If this

Â is apples, this is oranges, what is this? Bananas. [laugh] Because one year has

Â passed, that's [inaudible]. However, the interest rate is very high. So, what do

Â you I to do? I have to take this amount. Take 1,452 / 1.1^2. Which turns out to be

Â I'm going to go sideways here now, 1.21. If you do this, I believe you get 1,200

Â again. I set up the problem so that I can, you know, get wrong numbers and so on. So

Â what is the NPV, 2400, -1000, right? So, 200 was the first periods value creation

Â and so it's 1400. So, let me just make sure I've got this number right, and I

Â believe I have. But I want to do one last thing before we talk about NPV overall.

Â And what I'm going to do is I'm going to use Excel to generate these, these numbers

Â so I am going to rehearse. And there's a trick and unfortunately there's a little

Â bit of a hassle in doing NPV which I want introduce also, so let's do this problem.

Â So, in cell one, I'm going to put -1000. Please remember it's an A cell, A1. And

Â I'm putting all these numbers in there because eventually when you're doing a

Â more complicated problem, the beauty of Excel is you can put all the numbers in

Â and then, you know, you can modify it and so on and so forth. What is the next

Â number? The next number is 1320. And remember, I'm doing exactly the same

Â problem that we just did. What is the last number? 1,452. So, these are the cash

Â flows. You have - 1000, 1320, 1452. Now, what I want you to recognize about NPV is

Â there is a little bit of an issue with it. So, I'm going to do NPV, open parenthesis,

Â the first number that always jumps out at you is always rate, right? So, 0.10. Now,

Â here's the thing that already is on the website, a resource saying how to use

Â Excel, which Nate, my [inaudible] has created for you. And he has highlighted

Â this issue, but I wanted to do it real time too. You do not want to put the

Â investment there. It is set up to do PV, so the first payment is starting in cell

Â B1, right? So, the first payment in the future is one year from now, so you look

Â B1: C1, alright. But then you recognize that this is just a PV. So, what do you

Â have to do? You have to take account of the NPV part of it. So, what I'll do is

Â I'll add A1. Why did I add A1? Because I know if I add A1 and A1 is already

Â negative, as it should be, because it's an investment, what, what do I get? I get

Â 1400. So, this allows you to use Excel, the only thing that I would encourage you

Â to remember is Excel NPV is a rarely doing PV of future cash flows so don't give

Â times 0's information or the cell, the first cell information in your cash flows.

Â Of course, please remember how do you get cash flows, we'll do next time. But think

Â of these as profits and the first period times zero is an investment, okay?

Â