Welcome back to our course, Decision Making and Scenarios. I'm Professor Rick Lambert of the Wharton School and we're going to be continuing Module Four where we're talking about analyzing a new product venture. In this lecture, we're going to talk about how to calculate the NPV and IRR of the project. This is what we've been doing all the setup to be able to come to the calculation of, is this a valuable project or not? So we've talked about setting up the spreadsheet, forecasting out the financial statements into the future. The forecasted future cash flows and now we are going to talk about using those future cash flows to calculate the NPV of the project. So, we're going to take the forecasted future cash flows from before. So we started with trying to calculate the operating cash flows. Started with net income, added back the depreciation expense, adjusted for changes in working capital that gave us our operating cash flows, then we're also going to consider the investing cash flows. These are the investments at the beginning during the initial period and also the disposal costs at the very end. Put those into the bottom line, the net cash inflow or outflow. And now, we've got both the timing and the magnitudes of the cash flows. We need to calculate a present value. To do that, we need a discount rate. So, the discount rate is intended to represent the opportunity cost of our capital. This is the rate we could earn on our next best use of capital of equivalent risk. We said that we would use 6% for purposes of our example. Now we could calculate the present value cash flow by cash flow, brute force or we can use the functions that Excel already has set up to do this. So the NPV function is the one that's going to calculate a net present value, but remember that the NPV function assumes that the first cash flow is one period out. In our example, the first cash flow is now. So, just applying the NPV function to all the cash flows will mess it up. So instead, we want to calculate the first cash flow by itself. That's the $70,000 initial outlay and then take the remaining value of the present cash flows. If we do that, those have a present value of 96,624. And our overall NPV is then positive 26,624. The internal rate of return or IRR, also has a built in function for Excel, we can apply that to the stream of cash flows in total and that's going to say, 11.5%. So, what do those numbers mean? Well, let's start with the NPV calculation. NPV of 26,624. This is the economic value that the new product venture is going to add to the firm. This considers both the timing and the magnitude of the inflows, and outflows of cash, and it should also reflect the riskiness associated with the cash flows as well. That is the discount rate is supposed to reflect the riskiness. So this is saying, this project adds $26,624 of value. What does the IRR mean, 11.5%? This means that the money that we've invested in a new product venture is going to earn a rate of return of 11.5%. Again, this takes into consideration both the timing and the magnitude of the inflows and the outflows. Since 11.5% is bigger than our cost of capital of 6%, this is additional evidence that this is a good project. If the cost of capital was 11.5%, the same as what we're earning here, the NPV of the project would be zero. If the cost of capital was bigger than 11.5%, this would actually have a negative NPV. This would be a project that would be destroying value or losing money. How believable are those numbers, though? They look precise. I mean, we calculated them to the dollar. We've got this spreadsheet with all of these dollars in there. We could do them even to the penny if we wanted, but they're really only as credible as the quality of the inputs that went into the spreadsheet. These are parameters that we put into the assumptions section of the spreadsheet. But these area all judgments or estimates, or even guesses about the future and about what our business strategy is going to be in terms of how it's going to play out over time. We can't possibly be 100% accurate in those predictions, so we need to think about alternative scenarios for how things might turn out. So even though we've calculated an NPV and an IRR, we're not finished. In fact, we're just starting. Now, we want to start to ask hard questions. What can go wrong? How wrong can it go and we're still okay. Try to think outside the box. Re-think all of our assumptions. How could we do this better. Ideally we've set up the spreadsheet in a way that's going to allow the series of future financial statements. Future cash flows and the NPV calculation to be easily recalculated under alternative scenarios and that's what we're going to turn to next.