[MUSIC] Some of the most sophisticated analysis of a firm's new projects focus on a few cash flow components. Before looking at these, let's lay the groundwork of how to look at the size and timing of cash flows for any given project. Now, to visualize this framework. Imagine building an Excel spreadsheet with the rows representing the cash flow component and the columns representing time. The final row, which we will get to in a moment will represent the total cash flow. The in flow and the out flow over time. This row is going to show how the total changes at each time period, and where we apply some of the techniques that we learned earlier. Including the payback method, the NPV method, and the IRR method. For now, let's build the spreadsheet and simply list the six components that comprise it. Let's start that right now. So I'm going to begin by noting all the cash flow components. As I mentioned on the rows, I'm just going to make a list right now of what these are. So we have basically five components. The first component is the initial investment. I'm just going to jot that down. Initial investment. The second one is going to be the changes in what we call working capital. Explain all of this in a moment. The third one is the bread and butter of the after tax operating income. After tax operating, Income. The fourth one is the depreciation tax savings component. Depreciation tax savings component. And the final component the fifth one, what we call opportunity costs. Opportunity costs. Of course, the goal is to add all of these up, which give us the total cash flow. That's where we want to get at. So, as I mentioned the rows represent the particular components. So let's just draw these out. Here's our first row. Our second row. Third, fourth and the fifth one. And then of course, we want what we're going after the final row. The total cash flow, which is right here. As far as the columns are concerned, those represent the timing of these cash flows. And so if we draw those out quickly, we can have time period zero as the first column that's right here. That's time period zero. Then we have time period one. Time period two, time period three, and then of course, depending on how long your project is for. This could of course continue on till time period T, right? So let's look at each of these cash flow components, and let me introduce them to you. The first row, which is the initial investment, and this will include capital assets like machinery and equipment that will be used in the project. Working with the previous example of introducing a new organic snack food called Beat It, that you might recall. Let's just assume the initial investment, including installation of the new equipment is going to cost $21,000 today. And we're going to assume, as we did last time, that this is a three year project. And for simplicity, we'll also assume that the initial investment will not be recovered with any salvage or scrap value. So that amount will be zero. So in terms of cash flow. The $21,000 represents a decease today, where as the salvage value would be something we would recover. That would be a positive number in the future, but as mentioned we'll keep that number zero. So what do we put in? We put in the 21,000 right here, and if we had salvage we would add it. But this time, we're simply going to assume the salvage value is zero. [COUGH] So that takes care of our first item which is the initial investment. Let's look at the second item which is working capital. Now this working capital is the difference what accountants classify as current assets and current liabilities. I'll note that down for you separately here. Current assets minus current liabilities is what we call working capital, which is what we put in here. So, what do these items include? Current assets include things like receivables, which are sales made on credit and inventory, which are the goods produced. But they haven't been sold yet. So what we keep in stock. The current assets, you can imagine as I've described them. They eat up cash, or they tie up cash. So when current assets increase, we know that cash flow will decrease. But just the opposite is true for current liabilities, which include things like, taking out a loan from the bank, or paying your suppliers later on, payables accounts payable. So in this case, you keep your cash or you get cash from the bank, which means when current liabilities go up, cash flow also goes up. Therefore we want to take the difference, which is called working capital. Which means if you have more current assets that current liabilities your cash flow is going to be going down. Now as I mentioned in the previous video we only look at that changes in working capital, and that's very important. So we're going to see how these amounts change over time, and that's what we will record in here. Now, when this project is over in year three. Whatever investment we make, accumulated investment and working capital actually gets recovered in year three. So the sign changes, and I'll explain that in a moment. Okay, in effect what we're saying is that the investment in working capital which spontaneously changes every year get's recovered when the project is over. Now for our particular example. Let's suppose that we require a one time investment of $2,000 in working capital, and we require that right now, immediately. And let's also assume that the 2,000 is going to remain unchanged for each of the next three years. How is that going to be reflected in our cash flows? So what we do is of course, we record the immediate investment and working capital which is 2,000 right now. But because the number would be the same for each of the next three years, there is no change. So there's no investment here. There's no investment here. And there's no investment here, except I mentioned to you. Whatever you invest over time is what you recover at the end. So the minus simply becomes a plus at the end of the third year when the project is over. And that takes care of our investment in working capital. Let's go to the third component. The third component is the after tax operating income. This is, as I mentioned, the bread and butter of the project. This is why you're doing this whole project. And so here we're going to focus on revenues generated through sales, and of course the expenses associated with their operations. The expenses are typically grouped into variable expenses that vary with production, and fixed expenses that stay fixed regardless of how much you produce. Variable expenses will include things like the materials you paid for, the ingredients that you use to produce your product, the supplies you need, and things as I mentioned that vary with production. Fixed expenses are like salaries, or heat, light, rent, utilities that you pay, which do not change for a given range of production. Let's suppose our estimates are, we're going to be producing 10,000 snack items, we're going to sell them at $5 each with a variable cost of $3 per unit and an annual fixed cost of let's assume $50,000 a year. Let's put all of those numbers together and see what they look like. So, if we draw a little earnings statement, I'm going to draw that here in the corner. Let's say our revenues, which we just said are going to be based on 10,000 units, sold at $5 a unit. That gives us the total revenue of $50,000, right? This is a 0. And then of course we have our operating expenses, we have variable expenses. And these, again, are for 10,000 units but these are $3 per unit, that gives us 30,000. It's often good to take the difference between these two amounts and that is known as the contribution margin. Contribution margin. And you can see, of course, that's going to be $20,000. So that's what is being contributed to your income as you've covered your variable costs. We must of course, just like we subtracted the variable costs, we must subtract the fixed costs that I just mentioned. And those fixed costs are going to remain fixed, I think I gave you an extra zero there. I'm going to assume the number is simply 5,000, right, and what does that give us? That gives us something known as the gross profit or gross margin. This is the jargon that's often used. The gross margin is $15,000. And now we're ready to pay our taxes. This is also our taxable income, right. So the gross margin, we're going to apply our taxes, we will subtract them now. We're going to assume a tax rate of 40%. So 40% of this amount goes to the government in the form of taxes. That works out to $6,000. And that leaves me with my item I'm looking for, the after tax operating income, Which you can see works out to be $9,000. Right, so this is what I'm going to be earning thanks to this investment in machinery, equipment, and working capital. I can now say, hey, our forecast should add 9,000 each year for the next three years as I analyze the cash flows of this particular investment, right. Let's go to the next item, which is depreciation tax savings. Now I just want to say up front, that there are many ways of doing this. The common way is for people to simply add depreciation to this amount because as we will see, depreciation is a noncash expense and that's one way of doing it. But I'm going to show you a much more insightful way and that way looks at exactly how much tax you save thanks to depreciation. So let me explain that. Let's start first of all what does this word mean, depreciation? Well, depreciation represents the wear and tear of assets that you are buying up front. Think about, for example, driving a brand new car right out of the dealership. As soon as you drive out, you know it's going to depreciate in value. It's because it's no longer new. And so, nobody wants to pay the same price for a second-hand car. Now, everything in the world gets depreciated and every government recognizes that except for two particular assets that do not depreciate. And they are, number one, land, and number two, securities like bonds and stocks, okay? Everything else the firm buys can be depreciated as a legitimate expense, just like one of these expenses here. So if depreciation is a deductible expense, what it does, as you can see, if I had another number here to reduce my profits, then I would be paying lower taxes. So instead of grouping them and lumping them here, what I'm going to do is isolate the impact of depreciation as a separate line item. Because, and the reason is because the amount of depreciation is usually significant. And with this method I'm going to show you, you can precisely see how much tax will be saved by making a claim on depreciation. So let's, in our example, say the government permits you to claim equal portions of deprecation for this asset that you bought over the life of this particular project. This actually is a method, and the method is known as the straight line method of depreciation. Straight line method. The straight line method simply takes the cost and divides that cost by the number of years the asset will last, or its useful life. In our example, I'm going to assume the asset that we've purchased, which is 21,000, will last for three years, and that clearly gives me a number of $7,000. That's the amount I'm going to depreciate each year, until the asset is worth zero. Seven, seven, seven. The asset will have been written off. Now, the way we see the impact of the 7,000 on our cash flows is to do something really simple, and that is to multiply this number by the tax rate. If I take this number and multiply it by the tax rate, which you will recall, is 40%, I'm going to get a number that's 2,800. That is going to be the amount I'm going to put in here. But before I do that, you might say hey, why? How does that work? How come the tax rate times the depreciation gives me my depreciation tax savings? How does that work? Well the way it works is, actually, I can show you mathematically how that works. Let's actually go through the example and see what would happen had I included depreciation, okay? Had I included depreciation as part of my expenses here, had I added depreciation here, let's say my depreciation of 7,000, if I included that here, right. I would still have the same numbers here, so I'm just going to carry this forward. 20,000 take 20,000. Now instead of subtracting 5, I will be subtracting 12,000. So 12,000 minus 20,000 is going to give me the Growth margin, this time of 8,000, right? On 8,000, I will calculate my taxes, 3,200, and that will give me the remaining amount of 4,800. Now, what I'm trying to show you is that by claiming an additional amount for depreciation, I have actually reduced my taxes. You can see, before I was paying taxes of 6,000, now I'm paying taxes of 3,200. And this difference, of course, is going to be exactly the number I calculated here, which is 2,800. So you can see I'm saving taxes, because of this extra claim, and that's what I want over here. So why do all these calculations simply multiply depreciation by the tax rate, which is what I wanted to do in the first place? So let's add the effect of depreciation on our cash flow, and that effect Is simply going to be recording an additional 2,800 each year for the next three years. Thanks to the claim that I'm allowed to make, which saves me taxes. Very good, we're almost there. We're now at our last item, and that is opportunity cost. What does this mean? Opportunity cost, you'll remember, has to do with the next best alternative forgone. It has to do with the kind of side effects that come from doing the project versus not doing the project. So what we're doing with this new bidded project is that we're assuming that the profits of another similar product line are going to reduce, because there will be substitution or erosion, okay? We'll assume that effect is going to be $1,000 annually. So because it's attributable to our project, we must pay for it, and that's why we have this line for opportunity cost. So let's see the overall impact. If this project is causing us to reduce profit of another product that we sell, we must pay for it and account for it here. So I'm going to assume that number is 1,000 and make sure that this impact is reflected in my cash flow. I'm now ready to calculate my cash flows. Let's use another pen to highlight the numbers. What do we have? We have -23,000 in time 0. That's what we need to spend today. This is real cash. What are we getting in a year? We're going to take the sum of these numbers here, which works out to 10,800. Of course this is a plus. Let's do it again. It's the same number, so the amount is going to be 10,800 once again. And then, because we have a recovery of working capital, the amount Is actually $2,000 more, or 12,800 for the last year. So folks, this is what we were after. This is exactly what we assumed in our previous video when we started applying techniques. These are the inputs that go into our techniques. And now, while we have this fresh in our minds, let's just apply the three techniques that we learned. The first technique, you'll recall, was the payback period model. The payback period said, how long will it take to recover this initial investment? How much time will it take? And it's not that difficult to calculate at all, because what I'm doing with the payback is I'm just accumulating the cash flows to see when I get this money back. I need $23,000. I'm getting $10,800 in a year. That means I still need $12,200. Now, you can see I'm getting another $10,800 in the second year. But if I do the math here, of course, I still need -1,400. You can see that I get that in the third year. To get the proportion, I simply divide the amount I need with the amount I'm getting. That's 1,400 divided by 12,800, and that gives me a ratio of 0.11, and so my payback is going to be 2 years 0.11, just over two years. That's the precise calculation, okay? Now, how do I decide whether I accept or reject? If the company's policy is that all projects must payback within, say, three years, this is an acceptable payback. If the policy is that the payback must be less than two years, then we would say reject the project, because your payback is longer. But that's a naive method, as we noted. We have two more methods left to decide whether we take on this project or not. The most preferable method we said is the net present value method. The net present value method simply says, take these cash flows that we've just computed, and bring them back in present value. And for that, of course, we need a discount rate. Let's assume, because this is a fairly risky project, and we'll talk about risk later on, that the discount rate is 20%, okay? So we're going to take each of these cash flows and present value them at 20%. Let's do that. So the first one is already in time zero. We don't have to present value this one. We need to spend $23,000, plus we're getting $10,800 in one year. The present value is going to be simply divided by 1 plus the discount rate, right? This is for one year. Then we do it for the second year. 10,800 divided by 1.2 for the second year. And we do it one more time. 12,800 divided by 1.2 is to the power 3. Do the math, and we've come up with a number, and that number works out to be $907. That is a positive number. It means we're creating $907 in value right now, which suggest that, go ahead, except that project. It's a good project, because it creates value. And that takes us to our final method, and that method was the IRR method. The IRR method said, what we do is we set the value of this equation for NPV to equals zero, okay? And we'll look for the discount rate, because it's a return. We're looking for it this time. So if I have to set it up, it's going to look like this. 23,000 plus 10,800. But this time, I want to find the rate, which is the IRR, for one year, and then I want to do this again. 10,800, one plus the IRR for the second year. And then, the third one, 12,80,0 one plus the IRR for the third year. I have an equation with one unknown. I use my financial calculator and out pops the IRR. Which of this example is going to work out to 28, close to about 28%? Precisely 28.42%. How do you decide about the IRR? Well, you decide by comparing the IRR with your return that you have to earn, which in this case is 20%. So since 28% is greater than 20%, again, we've come up with a consistent recommendation that we should accept this project, and we're happy about this, because the result is to go ahead. [COUGH] So there you have it. You've had an inside look at how financial experts think about each cash flow component. And by the way, for almost every project in the world, this is basically what you do. These are the five cash flows you attend to. They typically include the initial investment. They include some changes in working capital. They include some positive amounts, hopefully, which is why you're doing the project. The after tax operating income. They include the impact of the depreciation. And as I said, isolate these, that's a good idea, because you can actually control these numbers. And then of course, some opportunity cost, and of course you can adapt this and fine tune this if there are some other nuances specific to your project. Not surprisingly, in sum, we need to get good at building these cash flow statements, and we need to use these investment techniques, which is what it has done in practice. We need to see how the moneys flow in and outside, and that's a process that we need to practice on until you feel really comfortable about doing these kinds of problems. And what we can do is try this with another set of information, which we're going to call a mini case. And we will show you some amount in that case. But this time, instead of asking you to do all this work, what you will do is you are going to try and identify if there are any mistakes that you can spot. And so, if you get these assumptions, and if you get the kind of drift about how do you proceed with the specific line items, you're going to have no problem at all in developing your skills, in looking at a cash flow statement. And that skill, by the way, is more than what many financial managers are capable of doing, and I'm sure you can acquire that very, very quickly.