Welcome back. These two weeks are important because we are going to talk about risk, and I have kind of held myself [LAUGH], put myself under control not to get into this. Because it would have been too much to take in unless you're familiar with the concepts. And if you're already familiar with the concept applications, you probably shouldn't be taking this class. So here's the big picture again. You know this formula. Please stare at it one more time. What are the ingredients of measuring value creation? We call value creation NPV. I naught is cash flow in period one, remember capital invested. C one, C two, C three are your profits in the future. We also call them cash flows. Do they necessarily have to be profits? No. Can they be negative for a long period of time? Yes. That's what's happened to almost every company. Why, because you initially do lose money. And you remember this is cash flows, and you may actually encourage the company to invest more than another company that's not doing very well or doesn't have great idea. So you may want to invest as an investor through the company aggressively and therefore, don't worry about cash flows being negative. In the long run, they have to be positive, otherwise, why the heck would value be positive? One quick question. Can the value of a company, a stock, or a bond be ever negative? The answer is no. And the reason is limited liabilities, so we almost always assume that. So this is the formula. What are the basic two ingredients for conducting any kind of value creation assessment? And by the way, it's the same tools that you use to figure out NPV is the tools you use to figure out PV right? So, if you want to evaluate an existing company like a lot of analysts do, the only missing piece is the net piece. You just still are looking at future cash flows, and figuring out the value. What are the two ingredients? Cash flows. Quick question, who do they belong to? By the way, they don't belong to anybody. They belong to all of us, in the sense of how the cash flows are created. But they belong to the project, the idea, the company. If the company, the project, and the idea, cannot reflect its cash flow, it's like saying I can't tell you who I am. What's my name? Where I'm coming? How will anybody else be able to figure who I am out? So cash flows are the signature of the project. The valuation, however, depends very critically on the cost of capital. In all our examples, what did I do including the one last week? I gave you the cost of capital. And if I remember correctly, it was I believe 12% when we were thinking about value creation. Where did you get that from, and who does it belong to? Let's answer the who does it belong to first, and then pretty much the next two weeks, or actually in the week beyond that, is about cost of capital. Who does this belong to? The marketplace, or the competition. Therefore all value creation is relative to the assessment of the competition. We assume that the law of one price holds, that r, if two things walk the same way, talk the same talk, you have to have the same value, right? Approximately at least. We have spent it some time on cash flows, I think we have spent a fair amount of time with one caveat that accounting was the one thing I would encourage you to either learn on your own. And I've given you resources in the syllabus and so on, or take a class. Take a class that'll help you sort through making accounting statements into financial cash flows. But deeply understanding accounting in the same way, like it's called financial statement analysis. And it can be very, very useful to you in your lives. We have also spent some time on two main sources of financing. Bonds, i.e., debt, shares, i.e., equity, and the reason we went there is not necessarily to understand financing but for two reasons. One, you have a direct connection to these, you take loans, you may invest in stocks, as I keep saying I wish more people had access to these resources in the world. Then the markets would be more phenomenal. However the reason we did it in this class, in the introductory class focused on value creation, you could have an introductory class focused on debt inequity. This class is based on value creation. We went there for one simple reason. We wanted to figure out the cost of capital, and only then the real world to actually figure it out practically is if you know how to value bonds and stocks. And one more piece, risk. And you'll understand what I mean as we go through this. So why risk and return? So we are after the cost of capital, the little r. That's our goal. Why risk and return? So the first thing, let me propose, is that different ideas/projects have different risks. I don't think this is anything new I've discovered. This is life, right. Different things have different risks. There's different returns. Let me ask you this, have you looked at a treasury belt? Yep. Have you looked at a stock? Yes. Have you looked at a bond? They all have different returns. Let's just talk about what we just did in bond pricing, which is riskier, a long term bond by the government or short term? By the same number long term because its price fluctuates more. Which is more riskier, a corporate bond or a government bond identical? Corporate, why, because the company promises to pay but may not be able to. Not because they are devious, but because they just trying to change like it happening last few years. Most people are risk averse and hence returns on ideas should be different depending on the risks, this is very, very key thing we are going to talk about. I hope you agree with this, that most people are risk-averse. In fact, it's been shown in experiments and in reality I'll prove to you that that has to be the case. If we are risk-averse, what's the problem? We don't like risk means, in order to take on risk, what do I have to do? I have to give you something that you like, and that something that you like is called return, okay? We therefore need to understand very critically because we are after return, we have to understand risk. Not only do we have to understand risk, because that's the one thing that determines return. We also want to know how to measure it. That's why I love finance. It is so awesome that it just doesn't talk about a concept, there's a practical way of measuring it as long as there are markets. And that's what's so cool about it, is that it's so intuitive yet measurable, yet real, not perfect, nothing is perfect. Only love is perfect, that's why finance is number two, okay. We then need to understand and measure the relationship between risk and return on different ideas to be able to figure out what the heck is that little r? Remember you have your cash flows belonging to you, your project, you've done your analysis. But the return that you need to discount those cash flows or evaluate your projects comes from the competition. But the competition has different risks, right. So your competition should have a similar risk to you. That's the key element, right, otherwise, apples and oranges. So we need to understand how to measure that risk. But then what's most challenging in some senses, after you understood that you should be able to translate it into a return that you can use to evaluate your project. It's called discounting because the return is usually positive. Correct? That's our goal. Valuing orange. So, let's set it up in the context of a company and idea of whatever. You want to evaluate an idea, a project, a firm that's launching a u-phone, a u-pad, and given its exceptional originality, we will call it Orange. And this is what the goal is, okay. I hope you like this because my sense of humor is so bad that I tend to laugh at my own jokes, but then I'm a happy guy. And that's one thing you want to know in life. If you're happy with yourself, the world will take care of itself. Okay, so be cool. We have projected all cash flows. So you have learned enough in this class to say okay I need to know my future revenues, I need to know my cost of goods sold, I need to know SGNAs, sales, selling, administration costs. Depreciation even though it's not a cash flow. Then I have to add it back, and then I have to worry about capital expenditures and working capital, look it's not that difficult to capture most of it. Except one thing I conveniently forgot, you have to pay taxes along the way. That's why you subtract depreciation and add it back, it helps reduce your taxes. How would you determine the cost of capital? Remember, remember the reason your going to figure out the cost of capital and your going to figure it out from comparable same risk, same business, same risk is because of the law of one price. And because all valuation is relative, nothing is absolute. All value creation is incremental and all value is relative. Okay, the fundamental problem, and this is, by the way, I'm going to I think it's best you take a break right now because you understand what we are trying to achieve. One more time we are trying to figure out the cost of capital of a company that has just started, or planning to start, called Orange. And we now need to figure out how do I discount my cash flows to figure out whether the NPV is positive or not, is this a value creating entity or not? So before we try to solve a fundamental problem that's posed by the real world, let's take a break and we'll come back, because the beginning of this class is a little bit intense. This class structurally is more intense. By that I mean fewer opportunities to do number crunching for two reasons. One, I'm setting up the problem. Why the heck are we worried about risk and return? And you need to relate to that. The second reason is that I'm going to jump into statistics because I have to. And I cannot assume that you know statistics, I will not. However I cannot teach you all about statistics. That even the statistics that we need I cannot, it's a class on its own, but I feel unlike accounting which is a language which you have to learn and understand. Statistics is a conceptually driven thing. I'll teach you enough and with Excel and some practice problems you can keep up to pace. But the class itself, this week on statistics, is going to be thinking, concept. I will go slowly but it's very important you get it before you do it, okay? Let's take a pause come back in a minute.
